New
front-end units have lower MER
Last
week, I highlighted a report that showed a rising trend in mutual fund
management expense ratios (MERs). MER (which is expressed as an annual
percentage of fund assets) is the fee that fund investors pay for professional
money management. While the industry threw up its arms in disgust at the
study’s conclusion, they failed to recognize the true weakness of the whole
system. But a new trend has begun that may somewhat offset this long-standing
weakness.
Canadians
and Americans share many similar habits – but investor behaviour isn’t one of
them. Americans love to take charge of their investments and make their own
decisions. Canadians, on the other hand, have a much greater propensity to
engage the services of a professional advisor to help in the decision-making
process – or to take it over entirely.
Most
investors simply don’t select investments and structure a proper portfolio in a
disciplined manner. Even if they had a process to follow, the task of becoming
informed on such a broad array of investment products is simply too daunting
for most. I know the art and science of investing very well but I spend my
entire workweek living and breathing this stuff. I certainly am no expert in
any other area – nor should individuals expect to become financial experts when
they spend most of their waking hours doing other things.
Hence, most
people want and/or need advice but are generally ill equipped to “fly solo”.
Once upon a
time, mutual fund investors saw 9 percent of their investment sliced off the
top as a sales charge (i.e. 9 percent front end load). In an effort to ease the
pain of commissions, Mackenzie Financial came up with something called the
deferred sales charge (DSC).
Investors
would no longer pay anything out of pocket on purchase. Rather, the fund
company (instead of the investor) would pay the up front sales commission
(usually 4 or 5 percent of the investment), plus an annual service or trailer
fee based on the amount invested (usually 0.25 to 0.50 percent).
But fund
companies don’t do this gratis. In return for compensating the investor’s
advisor, they had two conditions: a)
investors must keep their money in the fund ‘family’ for a stated number of
years – or face an exit fee for leaving, and b) investors bear a higher MER
than on the older funds that had only front end loads.
In other
words, we moved from a system of investors paying commissions directly when buying
to having it embedded into the fees that are skimmed off the top of their
investment on an ongoing basis. The good part about this is that it discouraged
the practice of some unscrupulous salespeople recommending lots of transactions
just to generate commissions (i.e. churning). The bad part is that the
transparency of commissions disappeared. Consumers in general, and investors in
this context, hate to see the fees they pay. It’s easier when it’s hidden.
There is a
natural parallel here with the GST vs. manufacturer’s tax. See this older
article for a more detailed discussion of fees.
When the
DSC gained popularity, most fund companies jumped on the bandwagon. Most
companies offered different classes of units for different sales charge options
– with fees to match. So, funds with only a front-end load had lower MERs than
those offering only a DSC option.
By 1995 or
so, all fund classes were merged into the DSC class. One class of units was
offered on which investors could choose either front-end load or DSC, but the
higher MER prevailed regardless of the choice – i.e. this is the current
structure.
The main
reason cited by the industry for scrapping the old model was ‘confusion’ on the
part of investors. While it was confusing for people to remember that they held
class A of one fund and class D of another, I’m not sure I fully buy the
reasoning since having to choose among 4,000 funds, many of which have similar
names, can’t be easy.
Investors
buying load funds will pay for the advice even if they don’t need it. They can
still buy other low fee investments and no-load funds, but the vast majority of
funds available today are load funds, which charge the full price for advice.
And even if the advice is needed and/or desired, embedded commissions result in
all advisors getting paid the same – when some may provide little or no
service, while others provide comprehensive planning. And of course, there’s
everything in between.
It makes no
sense to have this uniform compensation system when not tied to service
provided but rather a simple sale of product.
AGF has
initiated a step in the right direction that, ironically, may bring the
industry full circle. At the urging of broker Edward Jones, AGF is now offering
new D-class versions of their funds. D class units will offer a front-end load
option only and carry a lower MER in return. It is rumoured that AIM/Trimark
and Mackenzie will soon follow suit.
On this
trend, I’d love to see the industry play ‘follow the leader’. It just makes
good sense. It’s good for do-it yourself investors who need less service. And
it’s good for advisors that want to give their clients a break on fees,
whatever the reason.
Dan Hallett, B.Comm., CFP, CFA is the 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, Alberta, and Manitoba.