What You Need to Know about Fees - Part 1

Dymond Scruton Advisory Group - Oct 10, 2016
In this series, I want to provide investors some education about fees in the investment industry, so you can be better equipped to know what fee-structures are right for you.  Ultimately, we want investors to have comfort knowing they are getting goo

In this series, I want to provide investors some education about fees in the investment industry, so you can be better equipped to know what fee-structures are right for you.  Ultimately, we want investors to have comfort knowing they are getting good value for what it costs them.

In this first part, I want to focus on Mutual Funds.  Given the current and coming changes in my industry regarding the disclosure and reporting of fees ("CRM2" - to be outlined in a later post), I thought mutual funds would be a good place to start, given their more complex fee structure and lack of transparency.  

These regulatory changes are due to attempts by financial regulators to enact appropriate disclosing techniques and ethical processes among the financial advisory community.  You would think this would already be the standard - unfortunately not.  I could get into many examples of abuses of this, such as frequent trading solely for the purpose of generating commission revenue for the advisor, putting clients into illiquid DSC funds without their knowledge, etc., etc.  Email me if you think your advisor may be guilty.

Although the new regulatory efforts are a good thing and getting the industry headed in the right direction, they are also unfortunately promoting further unethical practices.  In this post, I want to outline one important example, focused around mutual funds.  

To start, here is an outline of a the fee structure in Canadian Mutual Funds.

What is an MER?  

The costs associated with running a mutual fund are included in the management expense ratio (MER) and charged as an annual percentage fee. There are three main components: i) Management fee – The cost associated with fund management, which includes having a dedicated team of professionals who actively research and monitor the fund, making adjustments when necessary to manage risk. The fee may also include a dealer and advisor component, which helps to pay for the services that we provide to our clients; ii) Operating expenses – Various administrative fees, including legal, tax and financial reporting costs; and iii) Sales tax (GST/HST) charged to the fund, which depends on the province of residence of investors of the fund.

For Canadian equity mutual funds, the average MER generally ranges between 1 percent and 3 percent. Any returns reported by mutual funds are net returns after all fees. 

What Makes Up the MER?

The following chart illustrates what the fees paid on a mutual fund, with an MER of 2.5 percent, can comprise:

Due to new regulatory requirements, the mutual fund industry and advisors have been focused on marketing "F-Class" mutual funds.  These funds are designed to be used in fee-based accounts and have a lower MER, that simply strips out the dealer/advisor trailer fee - typically 1% maximum and possibly lower).  In the fee-based account, the advisor determines the overlapping fee on the account.

F-Class mutual funds have been around since about year 2000.  However, they are only getting more notice now because of regulatory disclosure requirements.  Under these requirements, the only thing that is require to be disclosed to clients in the fee that advisors are receiving via a trailer, or in the case of a fee-based account, the overlapping fee.

What will not be disclosed in statements are the fees being charged by the fund companies.

What some advisors are doing, as a result of these regulatory changes, are putting their clients into fee-based accounts, holding F-Class mutual funds.  This is not necessarily a problem, as there are some benefits to a fee-based account and in the case of holding mutual funds, separating or stripping out the advisor/dealer fee/trailer.  One benefit would be that fee-based advisor/dealer fees are usually tax-deductable in taxable, non-registered accounts.  But, I digress.

The problem lies in the fact that some advisors are using this regulatory change as an opportunity to charge more to their clients for the same service.

For example, if a client holds an F-Class mutual fund in a fee-based account with a fee more than 1%, or over whatever the trailer would be in the equivalent A-Class fund, they could actually end up paying more.

For example, in the outline above, the fund shows an advisor/dealer fee of 1%.  The F-Class version of this fund would have the same MER, minus that 1%.  The advisor would then be compensated by the stated fee in the fee-based account.  If that was anything over 1%, say 1.5%, the client would actually be paying 0.5% more.  This can add up, especially over longer periods, as it lowers the net returns.

If this is all understood and agreed, based on the client agreeing to the value proposition and services being provided, then no problem.  The problem arises when this is not understoood.

Unfortunately, the regulatory changes only require fee-statements to show the advisor compensation.  As a result, in the above example, investors would only see a fee of 1.5% and think it is reasonable.

This is the reason why I think F-Class mutual funds can be more of a trick, than a true benefit to investors.

This is only one example for mutual funds and there are long lists of other things investors need to be aware of, including:

  • Holding mutual funds in discount brokerage accounts
    • Is there a trailer being paid for advice not given?...most often the case.
  • Mutual funds (or any fund for that matter) are not all created equal (to be outlined in another post)
    • ​Fund manager alignment of interests - skin in the game, compensation
    • Fund size
    • True Active Management - not just replicating an index/benchmark
  • Fit in overall portfolio
    • ​What purpose does it serve and is that aligned with the objective for the money?
  • Value being provided for the cost
    • ​Is financial planning advice being given, built around your objectives/goals and investment needs
    • Are service expectations being met?
    • Do you understand why certain holdings have been recommended, in context to your situation and what you want?

 

If any of these points sparks your interest, please email me to discuss further.  My team and I are always happy to provide feedback to investors that are not our clients, with no obligation.

 

Sincerely,

Jeff Scruton