Can you handle the truth?
Fund
industry may be forced to come out of the closet
Do you
remember when the goods and services tax (GST) came into effect? People
suffered a bad case of “sticker shock”. Consumers reacted as if an additional
tax was being introduced at the cash register. Many economists chuckled since
people became outraged at a situation that hadn’t really changed – it was a
perceptual change.
A
manufacturers tax had always been “hidden” into most sticker prices. The GST
simply “unbundled” that one price tag into two parts – the sum of which was the
same before and after. As a mutual fund investor, you should know that there
are some embedded costs to investing. Do yourself a favour: Get educated on the hidden costs you
currently bare so that you don’t suffer the same type of sticker shock down the
road.
Mutual
funds charge you for managing your money and taking care of all of the legal,
accounting and other administrative requirements. The fees charged for such
services are broken into two main components:
management fees (for the people making buy and sell decisions) and
operating expenses (i.e. legal, audit, custodial, and other fees). The total of
these costs is commonly referred to as a fund’s MER – management expense ratio.
The average
MER on Canadian balanced funds, for instance, is about 2.3 per cent per year.
For each $10,000 investment, that adds up to total fees of $230 per year. For a
$100,000 investment, that’s $2,300 each year. Since the fees are actually
calculated in percentage terms, the dollars move in tandem with investors’ fund
values.
The problem
is that many investors still don’t realize that any fees are charged. Worse,
even those that are aware of the MER’s existence have never thought about it in
dollar terms. I suspect the industry will be forced into clearer disclosure –
perhaps directly on statements – so it’s important for investors to get
educated about what they’re buying and what they’ve already been holding for
years.
MERs are factored
into fund unit price calculations daily and actually paid out of the fund each
month. In other words, it’s deducted “at source” just like payroll deductions
are withheld from your paycheque. The difference, of course, is that mutual
fund companies don’t show you a statement detailing fees paid over any period
of time.
Any unit
prices or published returns you see are net of the MER. There are a few
exceptions, but I’ve covered some of those in this June 2001 article (http://www.sterlingmutuals.com/Telus_PhantomFees_22jun2001.htm).
Mutual
funds are usually purchased in one of two ways. Buying on a front-end load
(FEL) means a commission is taken directly off the top of your investment
before it actually goes into the fund. For instance, a $1,000 investment
subject to a 5 per cent FEL would see $950 actually invested into the fund of
choice, with the remaining $50 taken directly as a commission, which is paid to
your advisor’s employer or dealer. This commission, if applicable, is in
addition to fund MERs.
Buying
funds on a back-end load or deferred sales charge (DSC) basis works a little
differently. All of your money goes right to work from day one. However, an up
front commission – ranging from 3 to 5 per cent – is paid immediately to your
advisor’s dealer. Since the fund company has paid an immediate commission, they
want to make sure your investment remains in a fund within their “family” long
enough (anywhere from three to seven years) to make up for their up front
liability and a profit margin.
That up
front commission is not paid directly by you, but is financed by the level of
MER set by the fund company. Hence, the MER is high enough to pay the salary of
fund managers, the costs involved in running a fund, and the commissions paid
by the mutual fund company (which means you pay it indirectly). Bottom
line: the up front commission paid is
included in the MER.
However, if
you buy a fund on a DSC basis but decide to cash out before the stipulated
period, an exit fee will apply. This doesn’t include moving between two
different funds in the same family (i.e. switching from Dynamic Partners to
Dynamic Fund of Canada). Rather, this exit fee (aka redemption charge) applies
if selling a fund from one family (i.e. Dynamic) and moving the proceeds to a
fund offered by another company (i.e. AIM/Trimark). If this redemption charge
applies, it is taken directly from the proceeds of sale of your fund, and is in
addition to fund MERs.
In both
cases, smaller ongoing fees, known as service or trailer fees, are paid for the
dealer or advisor’s ongoing service. Trailers usually range from 0.1 to more
than 1 per cent of the value of your fund holdings – and are typically higher
when funds are purchased on a FEL basis.
While so
called no-load funds don’t have a DSC option, some allow dealers to charge a
FEL and most pay trailer fees.
In the case
of any applicable commissions, the dealer receives the full amount, but then
shares most of that commission – 70 to 100 per cent – with the advisor, keeping
the rest to cover overhead.
While the
MER accounts for most of an investor’s costs, there is another fee that is
buried even further in mutual fund financial statements – brokerage fees.
Brokerage fees are incurred every time a fund manager buys or sells a stock.
Since most fund managers oversee large pools of money, the cost per trade is
pretty cheap. However, for fund managers that can be described as a bit
“trigger happy” (i.e. high trading frequency) brokerage fees can get so high
they double the published MER.
Why aren’t
these fees included in the MER? Because, from an accounting point of view,
they’re considered expenses incurred on account of capital. That is, they’re
not expenses incurred in the operation of the fund. Hence, brokerage fees are
included in the cost of the stocks purchased, or deducted from the proceeds of
selling stocks. While previously excluded items, like GST and interest expenses,
are now included in fund MERs, brokerage fees remain hidden.
For an
illustration and a more detailed discussion of this topic, take a peek at this
summer 2000 article (http://www.sterlingmutuals.com/account_jul.htm).
Most
sectors of the financial services industry are based on trust. Whenever a
trust-based industry undergoes explosive growth, the regulatory environment
can’t change fast enough to address all of the necessary issues. Sales
practices have been targeted in the past. My guess is that disclosure will be
the next focus of regulators in future securities legislative changes – long
overdue.
Investors
seeking advice from brokers, planners or advisors should look for those who
voluntarily stay ahead of the regulatory regime by laying out all of these
things very clearly, in writing, for clients before they sign on the dotted
line.
Seasons
Greetings
On behalf
of all of us at Sterling Mutuals Inc., I would like to extend my sincere wishes
to all of you for happiness and health during this holiday season and
throughout 2002.
Next
column: January 4, 2002
Dan Hallett, B.Comm., CFP, CFA is Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.