Just as one would be suspicious of food the chef himself won't touch, investors should be leery of funds their portfolio managers don't own. In the case of the former, diners suspect dodgy ingredients, and in the latter, fund investors question management's confidence in their strategy and investment capabilities. Heavy personal investment, by contrast, demonstrates conviction in the investment process and aligns managers' interests with those of the fund holder. When their own nest eggs are at stake, co-investment incentivizes managers to avoid excessive risk.
Coinvestment isn't the only driver of behaviour. Managers often tell Morningstar analysts that their bonus compensation drives their investment decisions. Not surprisingly, we've observed that managers given incentive to outperform over shorter periods tend to invest with shorter time horizons. Managers paid to deliver strong long-term performance are more likely to focus on the long term.
Morningstar studies manager coinvestment and pay structure as part of its Stewardship Grade, which measures how closely the interests of fundholders and fund companies align. Fortunately, fund managers have more closely tied their financial interests to fundholders' in recent years, as a new Morningstar white paper indicates. The paper details managers' rising co-investment levels since the Stewardship Grade's 2010 Canadian debut, though there hasn't been much of a move toward compensation structures oriented on the longer term. (The Stewardship Grade also considers the quality of a firm's corporate culture, whose recent evolution we described on Wednesday as well as fees and regulatory history, which will be covered in this article.)
More disclosure, more coinvestment
When the Stewardship Grade first launched, a large number of fund companies were reluctant to disclose portfolio-manager compensation data, usually citing privacy concerns. These worries abated in the ensuing years, with the number of firms providing no information falling from 10 to four by 2013. The combination of improved disclosure and better practices has led to improved Manager Incentives grades since 2010, as Exhibit 1 shows.
Exhibit 1: Evolution of Manager Incentives, 2010-13
We measure co-investment by looking at how much managers invest in their funds and those of their firm in proportion to their annual salaries. We created our co-investment standards by observing industry norms. Historically, we've rated firms as above average if at least 75% of managers hold more than a year's salary in their firms. Just seven fund companies met this standard in 2010, versus 15 in 2013. The increase partly reflects increased disclosure. Portfolio managers may have already had heavy coinvestment, but we didn't yet know it.
In other cases, manager coinvestment levels rose. The proportion of Fidelity Canada portfolio managers with two to three years' salary invested in the firm's funds rose to 78% in 2013 from 44% in 2012, for example, while those with more than three years' salary climbed to 54% from 22%. With the possible exception of Francis Chou, who says he invests tens of millions is his eponymous firm's funds, Fidelity's coinvestment levels set the industry standard.
One reason coinvestment levels have risen is because more fund companies require it. The number of firms with mandatory co-investment policies grew from six to nine from 2010 to 2013. This camp includes AGF, which announced in 2013 it would expect managers to invest at least two years' salary in AGF funds over the next three to six years, and Brandes Investment Partners, which will eventually require managers to invest three years' salary in Brandes funds. AGF and Brandes joined TD, Franklin Templeton, Dynamic, Leith Wheeler, Investors Group, Manulife and (in part) CI Investments with manager coinvestment requirements. (Manulife is new to Morningstar coverage and wasn't counted in 2010.) Some, like Leith Wheeler, mandate coinvestment as a multiple of salary, and others, such as Dynamic and Manulife, pay at least part of management's variable compensation in fund shares.
Other firms aren't as distinguished on the coinvestment front. In 2013, 70% of Fiera managers had less than a year's salary in Fiera funds. Instead, many of the managers appear to invest more heavily in company stock, tying their financial incentives more closely to the company rather than to fundholders. In some cases, we still don't know the extent of coinvestment. CIBC says it does not track manager coinvestment, while otherwise strong steward Beutel Goodman has not disclosed such data to Morningstar.
Manager pay incentives: Room for improvement
Canadian firms could do more to align their bonus compensation with long-term performance. Only nine of 27 firms in our coverage universe specifically gear their compensation schemes toward long-term performance, which we define as four years or more. (There were seven in 2010.)
By and large, Canadian firms reward short- and intermediate-term performance. The standard industry practice is to base variable compensation on one- and three-year returns, weighing the three-year period more heavily. For instance, two thirds of AGF's bonus is based on three-year performance, with one third tied to one-year numbers.
This is not to say bonus schemes should not consider shorter-term periods. After all, the long-term is composed of a series of short time periods. However, without a long-term component, managers may take undue risk to generate big near-term gains. Invesco Canada gives one-year returns a 25% weighting in its bonus calculation, while giving both the three- and five-year periods 37.5% weightings. Mackenzie ties 40% of its bonus to five-year performance, with 24% to the three-year numbers and just 16% to the one-year period.
A better practice is to reward performance over full market cycles, which typically take place over five to seven years. CI subadvisor QV Investors bases bonuses solely on five-year performance. Capital International's bonus scheme is based on one-, four- and eight-year periods, with the four- and eight-year numbers weighted more heavily. Black Creek, another CI subadvisor, bases 80% of its bonus on five-year returns and issues equity in the firm based on 10-year returns. Equity ownership can give incentive to managers to put their firm's interests ahead of fundholders, but CI Black Creek's approach ensures such ownership only happens when managers serve long-term investors well.
We look skeptically upon compensation tied to growth in firm assets, especially when combined with shorter-term performance incentives. That is the case at BMO, where up to 10% of compensation is tied to asset growth and the bonus is based on one- and three-year performance. Moreover, because BMO does not disclose manager coinvestment, we don't know if the managers invest in BMO funds. Taken together, BMO's manager-incentives scheme appears tilted in favour of shorter-term factors.
Economies of scale for me, not for thee
Money management is a great business. Once an investment manager reaches a critical mass in investment and support personnel, he can grow assets at little or no additional cost. Because the fund manager spreads management expenses across a wider asset base, the cost of running the fund shrinks. In the Canadian market, it has usually been the money manager -- not the fundholder -- reaping the benefits of improving economies of scale.
RBC, already the largest asset manager in Canada in 2010 with $102 billion in total assets, grew to about $278 billion as of June 2014. Yet its funds became more expensive on a relative basis over the period. In 2010 and 2011, RBC fund MERs landed in about the 20th percentile of their respective peer groups. While RBC still remains one of the Canadian market's lower-cost providers, its line-up ranked in the 30th percentile on average by 2013. Meanwhile, Fidelity Canada's assets under management rose from about $75 billion to almost $95 billion currently. MERs land in the middle of the pack across Fidelity's line-up. Similarly, CI Investments grew dramatically, from less than $60 billion to $130 billion, while its fund MERs finished about right where they started -- around the 45th percentile versus their peer groups.
It does not have to be this way. In their U.S. home market, Fidelity and Franklin Templeton compete aggressively on price and ratchet down fees as funds reach certain asset thresholds. (The latter is common practice in the U.S. fund industry and among institutional managers in Canada.) Meanwhile, Capital International uses the same low-cost model in Canada as it does in the U.S., and it has reduced MERs as assets have risen. Less conventionally, Steadyhand not only discounts its fees as investors' accounts grow -- itself not an uncommon practice -- but also reduces fees the longer they invest with the firm. Because accounts (hopefully) become bigger with time, this is a double win for fundholders.
Some commission-based advisors get backseat, DIY investors get better deal
We include fees as part of our stewardship methodology because it is a simple test of whether fund companies treat fundholders fairly. For example, fund companies should treat fundholders investing through fee-only advisors as well as they treat those investing through commission-based advisors. The difference in management fees between a fee-only and commission-based series should be no more than the embedded sales charge, or trailer fee. For example, if the fee-only series, almost always called the F series, of an equity fund had a 1% management fee, then the fee for the commission-based series should be 2% presuming a 1% trailer fee. A fund company charging 2.5% earns an additional 0.5% at fundholders' expense.
This practice has come about as fund companies have sliced management fees on some or all F series funds to lure the growing ranks of fee-only advisors. These fee cuts have undoubtedly benefited a relatively small number of investors, but fundholders in commission-based series continue to pay the same relatively high prices. This camp includes a few large fund providers, including BMO, Franklin Templeton and Manulife. BMO Bond, for example, has a reasonable 0.45% management fee for its fee-only F series, but its commission-based Advisor series' 1.3% fee is 0.40% above what we'd expect given its 0.5% trailer. Such disparities exist across BMO's mutual fund line-up.
In other cases, the disparities are limited to one or a handful of prominent funds. That's the case at Franklin Templeton's fixed-income offerings, especially at its largest fund, $2.3 billion Templeton Global Bond. The F series' 0.75% management fee is reasonable, but its A series 
levies a 1.75% charge. Given the A series' 0.5% trailer, Franklin Templeton takes in another 0.5% from investors with commission-based advisors. Lastly, Manulife Strategic Income, the firm's second-largest fund, levies a 1.75% management fee for its A series , versus 0.8% for the F series -- 0.45% higher than one should expect given its 0.5% embedded trailer.
Because fee-only advisors tend to cater to wealthier investors, average account sizes tend to be higher in fee-only series, resulting in lower administrative costs. These costs, though, don't explain disparities in management fees between the commission-based and fee-only series. That's because administrative costs are captured outside of the management fee. (These costs, plus the management fee and taxes, make up a fund's MER.) While administrative costs can vary by series, the distribution channel should not have an impact on the actual cost of managing the portfolio.
This isn't to say fund companies giving commission-based and fee-only series the same deal on management fees deserve unqualified praise. CI, Invesco, Mackenzie and Scotia, for example, treat both distribution channels equally, but, with fees in line with industry norms, neither gets a particularly good deal. Firms like BMO deserve credit for giving some investors more-affordable options.
Lastly, fund companies have begun giving do-it-yourselfers a fairer shake. Until recently, only Beutel Goodman, Mawer, Leith Wheeler, RBC and Steadyhand offered no- or low-trailer options for the DIY crowd. Others only offered access through more-expensive advisor-focused share classes, charging DIY investors for advice they didn't get. Fortunately, DIYers now have more lower-fee options. In 2013, Invesco, Mackenzie and BlackRock launched low-trailer series geared to DIY investors, and BMO and Manulife introduced one for some of their funds in 2014.
Staying out of trouble
Morningstar studies fund providers' regulatory records for the same reason automobile insurers pay attention to driving records. Just as insurance companies believe drivers with a history of speeding tickets are less careful than those with spotless records, we presume fund companies with regulatory black marks have had weaker compliance cultures than those that don't.
Since the Stewardship Grade's 2010 launch, no fund provider's investment personnel has run afoul of the regulators. This isn't cause for celebration. Following the law is a basic obligation. However, that no fund company has run into legal trouble should reassure Canadian investors that their fund providers' compliance-monitoring practices are up to par.
Editor's note: Today's article is the third of a three-part series this week, based on our manager-research team's newly released white paper on fund-company stewardship in Canada. Part 1 discussed the positive relationship between Stewardship Grades and performance. Part 2 focused on the evolution of stewardship practices in Canada, focusing on corporate culture.
