Canadian mutual funds are grossly overpriced and fund managers are ruthless profiteers preying on the stupidity of investors. At least, that’s the theory. The truth is that some companies can get their prices down to levels that still scandalize the critics only by sacrificing profitability and subsidizing funds’ expenses.

The issue of mutual fund costs has heated up lately, after U.S. research found Canadian funds were among the most expensive in the world. The implication is that fund companies are gouging investors and racking up windfall profits.

The truth is not quite so simple. To be sure, asset-management margins can be fat — at least, for companies with sufficient scale and efficient operations. Capital requirements are low, and large asset bases can generate correspondingly large and consistent revenue. Beneath the surface, however, many fund companies are scrambling to stay competitive.

Fund firms are coming under intense pressure to lower inves-tors’ costs. So, in an effort to keep management expense ratios looking somewhat respectable without resorting to lower management fees, some firms are paying a portion of their funds’ expenses out of their own bottom line.

The fact that some fund managers are struggling to preserve their margins and remain competitive was raised recently at an industry conference hosted by Scotia Capital Inc. Stephen MacPhail, president and COO of Toronto-based CI Financial Inc. , observed that some firms are quietly taking a hit to keep their MERs from looking bloated.

It’s not unusual for fund companies to subsidize expenses for a newly launched fund, but the remarkable thing is that some are doing it for very large funds with more than $1 billion in assets.

“It’s standard practice to subsidize fees of new funds because all involve a certain level of fixed costs,” says industry analyst Dan Hallett, president of Dan Hallett & Associates Inc. in Windsor, Ont. “This is often required for two to three years, until a fund has enough assets to be able to cover all of the costs and still have a competitive MER. But I have to admit to being shocked sometimes at the number of fairly large funds that still receive fee subsidies, however small.”

The fact that companies are still picking up expenses, even in large funds, suggests two things: they aren’t very good at controlling expenses or realizing economies of scale; and competition for sales remains intense and they are desperate to keep up.

There’s no question that industry competition is intensifying. Indeed, MacPhail told the conference that management fees are coming under significant pressure. The first step in the erosion of fees, he says, is investors shifting away from high-fee/high-expense funds toward lower-cost substitutes.

There have been numerous other forces driving down fees that fund managers receive as well. One is asset allocation. In the past few years, investors have decisively favoured income-oriented funds over equity funds — a shift that has been primarily the result of clients’ evolving investment preferences rather than as a way to lower costs. Nevertheless, income funds tend to be cheaper than equity funds.

There has also been a shift in the relative popularity of sales-charge structures. In the industry’s heyday, the vast majority of funds were sold on a deferred sales charge basis. Today, the popularity of DSCs has waned, and most funds are sold with front-end loads (which pay higher trailer fees) or no loads (thanks mainly to the banks). The introduction of low-load options and increased popularity of F-class shares has also put pressure on margins.

The recent unfavourable comparisons with the fees charged by U.S. and other countries only exacerbates the pressure Canadian companies are under to cut fees. Much of the heat is playing to the banks’ strengths, as they tend to offer funds with lower MERs. Indeed, banks already hold a pricing advantage over independents. A recent report by CIBC World Markets Inc. says asset-weighted MERs in bank-sponsored funds undercut those of the independents by an average of 31 basis points for equity funds and 40 bps for balanced, foreign equity and fixed-income funds.

Combine the various sources of pressure on fees with the fact that the industry is facing lower overall sales compared with the mid- to late 1990s and the squeeze on margins becomes even more intense. Firms are having to ramp up their sales and marketing efforts in a bid to capture the sales that are available or, at least, to retain their assets. These sales and marketing efforts are costly, particularly if they don’t generate much in the way of new assets.

@page_break@The competition for assets is also pushing fund managers to dream up new products and packaging solutions. These initiatives may help them win in the marketplace, but they also endanger the bottom line. The firms resort to paying higher trailers or issuing performance guarantees, which are strategies that could cost them down the road if their managers don’t deliver.

The practice of subsidizing some fund expenses is just another in a long line of sacrifices that firms appear willing to make to preserve their position without lowering their management fees before they have to.

Stephen Boland, an analyst with CIBC World Markets in Toronto, says that it’s really only the larger companies that can afford to subsidize expenses. “This is meant to marginalize the smaller players that cannot compete,” he says.

In the longer run, the practice of subsidizing expenses is just one more sign that the industry remains ripe for further consolidation. Looking ahead, Boland expects the efforts to marginalize smaller players to continue, and for industry consolidation to follow as companies have to merge to survive in this very competitive environment.

“Margins are declining, with lower management fees and higher trailers being paid. So, scale is more important than ever,” he says.

For now, decent market returns have cushioned the impact of the sales drought for many firms, allowing them to soldier on. But given that the direction of management fees is sure to be down in the years ahead and that demographics are no longer favouring strong demand, fund companies may be smart to focus on controlling their expenses if they hope to preserve their margins in the future.

“Not many companies can afford to subsidize expenses to a material degree,” Boland adds. “Consolidation will occur regardless, and some companies need to focus more on general expense reductions to improve profitability.”

So far, no one has tried to match CI’s genius for controlling expenses. Last year, it aimed to turn that operational strength into a competitive advantage when it unveiled a new method for charging its funds’ expenses, under which it established fixed administration fees for its funds, ranging from 17 to 22 bps. Some funds charge expenses that are multiples of CI’s fixed fee. It remains to be seen whether its competitors ultimately feel compelled to try to match CI’s miserliness.

IF FUND COMPANIES COULD AFFORD TO BE INSENSITIVE TO FUND COSTS, THEY WOULD SURELY HANG THE EXPENSES ON UNITHOLDERS. THE FACT THAT SOME ARE PICKING UP PART OF THE TAB HIGHLIGHTS THE FACT THE BUSINESS REMAINS HIGHLY COMPETITIVE. INDEED, IT IS PART OF A BROADER PHENOMENON OF FIRMS SACRIFICING THEIR MARGINS IN AN EFFORT TO GENERATE SALES. BUT IT ALSO RAISES QUESTIONS ABOUT THEIR ABILITY TO CONTROL COSTS. IE