By Jonathan Chevreau
National Post
FP Investing
Tuesday November 11, 2003

Fears the U.S. mutual fund crisis could spread to Canada were confirmed yesterday when Bank of Montreal fired Putnam Investments as manager of the $463-million BMO International Equity Fund.

U.S. based "subadvisors" are common in Canada, often showing up in foreign equity funds held in Canadian RRSPs as part of the 30% foreign content limit.

The bank's decision heightens the tension which started building last week, when the Ontario Securities Commission gave Canada's fund companies until mid-December to show why they won't be the next Putnam.

Putnam was charged with fraud Oct. 28 as part of New York State Attorney General Eliot Spitzer's mutual-fund trading probe. Its assets fell US$14-billion, or 5%, in the first week of November. Yesterday, it ran full-page ads to persuade clients its redemptions don't mean it's facing a liquidity crisis.

For Canada's fund executives the worst nightmare would be to become a northern Putnam. Little wonder other fund giants, like Fidelity Investments, have been proactive in reassuring worried unitholders.

On Friday, the Investment Funds Institute of Canada was quick to play ball with the OSC. IFIC president Tom Hockin stressed "there are significant differences in how the fund industry operates between Canada and the U.S."

True but if the media feeding frenzy over Putnam sparks a fund redemption panic, it could slam stocks and take Canadian equity fund investors down with them.

A media-fuelled fund redemption panic would be tragic, stopping the mini-bull in its tracks. Already the press is getting trigger happy. One headline Sunday read "Is mutual fund mass exodus next?" Headlines like that are more damaging than the shenanigans of a few greedy fund managers behind closed doors.

Personally, I don't feel any urge to dump my own modest fund holdings. Even if late trading and other abuses are found pervasive in Canada, in and of itself it would not be a crisis. It's how the public reacts to media reports of abuses which is the scary unknown.

The irony is the industry largely weathered the three-year bear market. Few equity funds protected unitholders from the bear's claws, but those who fled to the safe harbours of income funds, dividend funds, balanced and gold funds have enough dry powder left to benefit from the next upturn.

But because of the conflicts of interest in how Canada's fund salespeople are paid, many investors were overweight equities. That, and the higher fees that accompany equity funds, is one of the differences IFIC's press release glossed over.

Instead, the industry is putting on a happy face because they say late trading, or placing trades past the 4 pm cutoff deadline can't happen here. That's because fund trades are executed by the independent FundServ.

Several Canadian portfolio managers have been caught playing fund-closing pricing games in recent years.

RT Capital was caught manipulating stock prices to artificially boost performance. Strategic Value Corp. was caught manually y changing prices on some stocks in its funds, also inflating performance. Today, firms use "fair pricing" to prevent such abuses, says industry watcher Dan Hallett.

Even so, investor advocate Joe Killoran says "problems are the same in Canada, if not worse than in the U.S." Advocate Ken Kivenko says Canadian fund regulations and enforcement are "significantly looser than the U.S.," so investor concerns should be amplified.

Vancouver advisor Adrian Mastracci of KCM Wealth Management agrees U.S. fund problems "could well also surface here." Since they occur with actively managed funds, he suggests investors use low-turnover funds or passive index funds.

In his Internet Wealth Builder, Gordon Pape says the rising number of firms imposing penalty fees on investors who sell units within 90 days of purchase suggests "something has been going on."

But Pape says Canada has two bigger problems: high management expense ratios (MERs) and the built-in bias for equity funds. Equity funds have the highest MERs -- often topping 3% -- and pay higher commissions and trailer fees. So funds in other asset classes -- the very types that protected investors from the bear -- are sold less. "They don't make as much money, either for the companies or for financial advisors," Pape says. "Advisors have powerful incentives to sell them, even if they may not be the best choice for a client's portfolio."

The industry tells advisors to make client well-being top priority, but penalizes them if they underweight equity funds in client portfolios.

Where have we heard that before? Former OSC commissioner Glorianne Stromberg said as much in her 1995 and 1998 reports. Things are no better now: "I can't understand how anyone could say there isn't a problem in Canada without having looked into it."

Other fund Cassandras are also back in the news. The headline cited earlier topped a New York Times reprise of Donald Christensen's 1994 book: Surviving the Coming Mutual Fund Crisis.

Should you worry? Yes, if all your money is locked in high-MER equity funds and you borrowed money to do so. The flood of lawsuits from leveraged equity funds has just begun.

However, there's less to worry about if high-quality funds form just a part of a portfolio that also consists of bonds, individual stocks or ETFs, income trusts, real return bonds and other financial products.

It's the fund companies that should be worried.

NOTE: The information provided above is intended for general informational purposes only. It does not constitute advice for anyone's specific situation. Everyone should always first consult directly with their advisors to determine the appropriateness of any information contained above before taking any action. KCM Wealth Management Inc. assumes no responsibility for any loss or damage arising from the use of, or reliance upon the above information.