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Scudder's About Face
Canadians' preference for advice a factor

This week, unitholders of the original Scudder mutual funds (the classic series) got a lesson this week on mutual funds - the business. Scudder's news release (http://www.scudder.ca/release.pdf) essentially says that the original business model of selling funds direct to Canadian investors is no longer feasible. The administration of Scudder's classic series of funds is being handed off to Schwab Canada, with no new purchases allowed after January 25, 2001. The implications for unitholders are mixed.

Background

In 1995, Scudder made a big splash on Canada's mutual fund industry and they had a great story to tell. Scudder was/is one of the largest money managers on the planet with deep analyst resources and a disciplined investment style. The focus of their marketing campaign - low fees and seasoned management. In fact, for nearly a full year Scudder waived all of its expenses on all funds in an effort to attract the attention of thrifty Canadian investors. The strategy worked well at first but only with one fund - their flagship Canadian Equity. By 1997, this fund had amassed over $300 million in assets and was self-sustaining. The problem was, that one fund represented most of the assets in its Canadian fund family. With strong performance on all of their funds and the deep marketing pockets of its US parent, many thought Scudder would start the fee-competition ball rolling. However, it just didn't unfold that way.

Fee subsidies

1996 was Scudder Canada's first full year of operation. That year, Scudder "ate" nearly $1.2 million in fees and expenses - representing a whopping 5.28 per cent of average net assets. Without that subsidy, most of the fund's MERs would have been in double digits. By 1999, the firm had accumulated a respectable amount of assets, but still considerably lower than needed to make all of the funds self-sufficient. In 1999, Scudder absorbed nearly $2 million in management fees and operating expenses - equal to 0.31 per cent of average fund assets.

Despite Scudder's apparent commitment to keep fees low, there was always a problem for investors because they would always face the possibility of rising fees if assets didn't pile up high enough. Early Scudder supporters found themselves in funds with slowly rising fees each year - by about 0.25 per cent per year with some funds. An examination of historical MERs from Scudder's annual report shows that fees on all of their funds stopped rising in 1998, even though the firm continues to "pick up the tab" on nearly all funds. Further, it appears that Scudder's intent is to continue to keep fees at the previously capped levels. That is good news for existing unitholders. However, the heavy restrictions that take effect on January 26 will likely drive many unitholders out of the original funds. Hence, many investors are wondering why Scudder has taken this step.

Distribution, distribution, distribution

This latest move by Scudder is a lesson in the business side of the mutual fund industry. What location is to real estate, distribution is to mutual funds. If you look back over the last five years, those fund companies that targeted advisors as their main distribution channel (i.e. selling funds through financial advisors and full-service brokers) are the ones that survived - or were at least the target of a profitable takeover. It remains a fact that Canadians prefer to invest their money with the help of an advisor. Today, most advisors continue to be compensated on a commission basis and sell investment funds on a deferred sales charge basis (DSC). (Buying funds on a DSC basis means paying no commission up front but paying an exit fee if cashing out within six or seven years.) While decreasing flexibility for investors, the contingent exit fee and relatively higher MERs compared to no-commission funds make fund companies that follow this model more valuable businesses.

That's essentially what we're seeing with Scudder. While Scudder will keep the investment management responsibilities, they are handing over the job of administering the funds to Schwab Canada and focussing their efforts on marketing and administering the advisor series of funds (their higher margin product). Scudder's advisor series funds are identical to their original funds, except that MERs are substantially higher to finance the costs of commissions paid to financial advisors. Presumably, the investors in the classic funds don't need or want an advisor's help so the new development is not good news.

Bottom line

The only transactions allowed in the Scudder classic funds as of January 26 will be: dividend reinvestments and redemptions. No purchases or inter-fund switches of any kind will be permitted in these funds. So, flexibility is severely hampered. While many thought Scudder's Canadian debut was the beginning of lower fees in Canada, it actually has turned out the exact opposite. I suspect that the classic series of funds will eventually cease to exist - effectively forcing Canadian investors to pay the higher fees in the advisor series or in other funds.

It simply doesn't make sense for investors to have to pay fees for advice that they neither want nor need. All investors would be better off if the fee for general financial advice were separated from the fees for operating mutual funds. That way, only investors who seek advice will pay higher fees.

Investors who still want to buy low cost and good quality funds face a quickly shrinking list of companies. Beutel Goodman, Mawer, McLean Budden, Perigee, and PH&N are just a few of the quality no-load funds still available for the do-it-yourself investor to build diversified portfolios at reasonable costs.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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