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.
Management expense ratio (MER)
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.stingyinvestor.com/SI/funds/06292001.shtml.
Loads or sales commissions
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.
I would like to extend my sincere wishes to all of you for happiness and health during 2002.
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 firstname.lastname@example.org
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