Drunk from years of inflated stock prices, Canada's $300 billion mutual fund industry has awakened with a whopper of a hangover.
  During the heady days of the '90s, when even average funds were putting in 10 per cent gains, investors turned a blind eye to some very troubling signs. High management expenses, unjustified sales commissions, underperforming mutual funds and a lack of attention to clients were just some of the problems that affected the industry.
  Then in 1998, the fortunes of Canada's mammoth mutual fund business declined sharply. Now that stock markets are heading for lower long-term profits, investors are far less accepting of the industry's abuses.

Shareholders versus Unitholders
  Mutual fund companies are big players on Bay Street. In less than 10 years, the industry has grown from $50 billion in 1991 to more than $300 billion in 1998. In addition, large firms are publicly-listed companies that not only offer mutual funds to investors, they issue shares on stock markets.
  These companies, and even smaller, privately-owned firms, have to serve two very different groups: shareholders who demand high annual profits, and investors who have purchased units (unitholders) in the funds themselves. The interests of these two groups are very different.
 

There is a growing consensus that most mutual funds fail to deliver the goods

  Mutual fund critic Glorianne Stromberg, a former commissioner with the Ontario Securities Commission, argues that the drive to make profits has put tremendous pressure on sales representatives to sell mutual funds. This system prevents salespeople from spending enough time and effort educating investors about their options.
  "This pressure to manage for sales has become such a predominant force in the investment advisory industry that the line between managing money and simply selling product is no longer clear," argued Stromberg.
  Mutual fund companies derive their profits from management fees, known as management expense ratios or MERs. These are based on a percentage of the assets of the fund - usually about 2 per cent.
  Mutual fund companies earn rising profits by applying this MER to a growing investment pool. The way they make this pool grow is by offering marketing incentives to a sales force to attract millions and millions more dollars into their funds.

Mutual Fund Performance
  Mutual fund abuses are only a part of the problem in the industry. Investors could forgive these problems if they were getting value for their money. Yet there is a growing consensus that most mutual funds fail to deliver the goods.
  Mark Heinzl, a Wall Street Journal reporter in Toronto and author of the book Stop Buying Mutual Funds, points out that most mutual funds under perform the Toronto Stock Exchange.
  In his book, Heinzl looked at long-term mutual fund returns by comparing the TSE 300 Total Return - the overall performance of the Toronto Stock Exchange - with the average of Canadian equity mutual funds. He found that only 24 of the 75 equity mutual funds with 10-year track records to the end of 1997 were able to beat the TSE's average 10-year annual return. Over five years, only 21 out of the 123 were able to beat the TSE.
  Why have these funds been unable to beat the market? Heinzl maintains it is largely because of the management fees scooped off the overall returns. The fees go toward all the overhead needed to pay for fund administration, including salaries of mutual fund managers, marketers and administrative staff. It also includes the substantial budgets required to pay the millions of dollars worth of mutual fund advertising needed each year to attract investors to the big funds.
  "On top of all this, the fund company has to make a healthy profit to satisfy the investors who own the mutual fund company," Heinzl points out.

This article was excerpted from a chapter by Eugene Ellmen in Just Making Change: The 100 percent pure, honest to goodness truth about our user unfriendly financial system and how we can break free of it, edited by Lorne Nystrom, MP, and published by The Golden Dog Press. Eugene is Executive Director of the Social Investment Organization.