Rob Carrick recently did some analysis of mutual funds’ and ETFs’ MERs relative to their performance, which he calls FFI (Fund Fee Index) (see “How to get the skinny on your fund’s fat fees“). The FFI is supposed to be used as “a new way to measure the value you get from the fees you pay to your own mutual funds and exchange-traded funds.” It is calculated as follows:
Cute idea, but unfortunately it is a fairly meaningless measure since paying more expenses to a mutual fund company will not get you more gross returns (because returns are random). The big thing you will notice from the chart is that all the iShares ETFs scored far lower. In fact, as Carrick points out:
The best index score for a mutual fund was the 8.7 earned by the Phillips Hager & North Dividend Income. The worst score on the ETF side was the iShares Cdn Short Bond Index Fund at 4.8. Here, we have a vivid example of how the low fees of ETFs work to the advantage of investors. The ETF scoring worst on the Fund Fee Index beat the mutual fund with the best score.
That’s right, each of the 12 ETFs he chose beat the top 50 mutual funds of all types according to his FFI measure. He praises ETFs’ low fees, which is why the ETFs’ FFI scores are consistently lower than those of mutual funds, but stops short of making any grander conclusions. He says “it’s pointless to generalize about the value that investors get for the mutual fund fees they pay – some funds are outstanding, many are middling and some are pretty bad.” Maybe so, but we can definitely generalize and say that investors get much more “value” (I’m using Carrick’s definition of value here… a low FFI) out of ETFs than they do from mutual funds.
In general the FFI is a useless measure. Here’s an example. If a mutual fund or ETF had a 5 yr. annualized return of 1% and an MER of 0.1%, we get an FFI of 11 . Let’s say another fund or ETF had a 5 yr. annualized return of 20% with an MER of 2%. That gives the same FFI of 11 . So what does that tell us? That these two investments are equally “good”? The FFI hides the returns and in the end doesn’t tell us anything.
The only way in which the FFI is moderately useful is for comparing funds in the same sector or market. Then we can truly understand why the ETFs have lower FFIs than the mutual funds and what that actually means. The FFIs for the ETFs range from 0.9 to 4.8. These are ETFs such as iShares CDN Composite (XIC) with an FFI of 1.3 and the iShares CDN Short Bond Index (XSB) with an FFI of 4.8. The gross returns of the mutual funds should, on average, be equal to the gross return of the iShares ETF in the same category (because the gross return of the iShares ETF is the market average’s return). So when comparing ETFs and mutual funds in the same sector, the only variable affecting the FFI score is the MER. The higher the MER, the higher the FFI. So for this specific case, the FFI basically just becomes another measure for the net return, and as Rob Carrick says “The ETF scoring worst on the Fund Fee Index beat the mutual fund with the best score.” But what he is really saying here is that in any given sector, the iShares ETF for that sector had a higher net return than all the mutual funds in that sector that he looked at.