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Fund industry coming full circle
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.

Advisory services

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".

MERs and commissions - a brief history

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.

Coming full circle

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, 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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