Unlocking the DSC Handcuffs

Restructure portfolios without incurring charges

I’ve spoken to countless investors who feel trapped in crummy portfolios but feel tied by the deferred sales charge (DSC) schedule they incurred upon initially purchasing their fund. Investors in this situation typically hold between 15 and 20 funds on a DSC basis in five or six different fund families. While the DSC structure allows financial advisors to be handsomely compensated for their work, it can hamper portfolio flexibility when changes are necessary. First, a primer on the DSC structure.

When buying funds on a DSC basis, the mutual fund company pays your broker or dealer a commission up front - usually 4% to 6% of the amount invested (with a portion going to your advisor). This commission is included in fund management expense ratios - MERs. If you decide to sell out of a family of funds (i.e. sell AGF to buy AIC) within the first 6 or 7 years of your purchase, a declining exit fee (starting at 5 to 6 per cent in the first year, declining to zero in 6 or 7 years) will be charged at the time of withdrawal. This contingent exit fee is withheld at source and is in addition to fund MERs. Assuming you’re stuck in a bad DSC portfolio, here’s my prescription to ease the pain.

Take advantage of “freebies”

Most fund companies allow 10 per cent withdrawals of fund holdings each year without triggering a DSC fee. To determine your exact “free withdrawal” amount, call your financial advisor or fund company because some charge the fee (and determine free withdrawal amounts) on market value while others base it on book value. Most also include cash distributions as part of this free withdrawal amount. “Free withdrawals” are not cumulative so they must be exercised each year to be effective in reducing your exposure to DSC funds.

Ask for a rebate

If you bought your funds on a DSC basis, you probably did so through a financial advisor. If you still deal with an advisor, ask about DSC rebating. Rebating involves selling the old fund and buying a new fund from a different family. The commission earned on the new purchase can be directed by your dealer to offset your exit fee on the sell side so that you’re able to make changes without incurring any out-of-pocket costs, but a new DSC schedule is started. Outside of your RRSP/RRIF accounts, this rebate is taxable, but can be deferred by simply filing an election with your tax return. Instead of being tax as income in the year received, the election effectively results in the rebate being taxed as a capital gain when the fund units are eventually sold. Visit a tax pro to make sure this election is done properly.

To my knowledge, Scotia Discount and Sterling Mutuals are the only discounters still offering the DSC rebate. While Scotia’s rebate is 3 per cent, Sterling Mutuals is the only one offering to rebate the full 4 to 6 per cent DSC commission to investors. Investors need only ask to receive this rebate.

Restructure

Okay, so what if you’ve exhausted your free withdrawals and you don’t like the rebate idea? Then it’s time to take a deeper look at your portfolio for fine tuning opportunities. Examine the fund families you hold and determine the strengths of each. Then, see if you can make a few switches to give your portfolio a boost. Suppose you hold Templeton Canadian Stock (30%), Dynamic Income (35%), and Trimark Select Growth (35%) in your RRSP - all on a DSC basis. A few simple switches is all it takes.

Franklin Templeton: sell Templeton Canadian Stock and buy Templeton Growth.

Dynamic: sell Income and buy Fund of Canada.

Trimark: sell Select Growth and buy Canadian Bond.

The above switches will save you in annual fees, should improve risk and return, and are possible without incurring any transaction fees. However, always watch out for short-term trading fees and foreign content violations. Outside of registered plans, like RRSPs, RRIFs, and other variations thereof, you’ll also have to keep good track of the tax implications.

DSC funds aren’t evil. The DSC structure compensates financial advisors for the work they do for clients. Most advisors provide value-added advice to their clients. It’s when the advisor’s work isn’t so hot or when the details of the DSC aren’t disclosed to investors that the inflexibility of the structure is painfully apparent. If you’ve got an ailing portfolio, hopefully the above tips will help you to ease the pain without costing you a fortune.

Dan Hallett, B.Comm., CFP, CFA is Senior Investment Analyst with Sterling Mutuals Inc. Dan can be reached by e-mail at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a mutual fund dealer in Ontario, British Columbia, and Manitoba.