Investors don’t have to wait for Canada to bury trailers

Canadians already have lots of options for buying commission-free mutual funds—either as a DIY investor, or through low-fee mutual fund companies. If the industry is slow or unwilling to change, an educated investor can avoid trailers and keep more of their returns.

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negotiation_0211_322Sparks flew during a panel discussion at a recent meeting of the Ontario Securities Commission when the topic of eliminating mutual fund trailing commissions was tossed onto the debate table. It’s hardly a novel talking point, as an overhaul of Canada’s mutual fund fees has been long overdue. But not surprisingly, there is fierce division over making radical changes to Canada’s current mutual fund fee structure.

What’s at stake? For starters, boatloads of money. Numerous published research studies already show that Canadians, on average, have the highest mutual fund fees in the world—our annual management expense ratios (MERs) range between 2% to 3%. Most of that cost covers investment management and operating expenses for funds, while about 1% goes to advisers in exchange for ongoing service in the form of trailing commissions (also commonly known as a “trailers”). The latest statistics provided by the Canadian Securities Administrators (CSA) showed that in 2011 mutual fund investors paid $4.6 billion in trailing commissions to advisers and their firms, representing 34% of total revenue from MERs for that year.

One of the arguments you’ll hear in favour of trailers is that investors, of course, are receiving valuable advice from their advisers. While that could be true (also keeping in mind that dispensing advice shouldn’t merely constitute setting asset allocations and buying funds on behalf of a client), it’s entirely simplistic and convenient to solely frame it that way. For starters, these trailers are embedded within the MER, meaning most mutual fund investors probably aren’t even aware of the arrangement. Don’t get me wrong, advisers deserve to get paid. But don’t investors deserve to have the nature of that payment explained to them explicitly before any funds are purchased? (As it stands, advisers in Canada aren’t required to bring this up unless you ask, and arguably many mutual investors aren’t even aware that advisers’ advice isn’t free.)

The CSA is certainly pursuing a new path. The organization to date has been pushing for regulatory changes that would improve transparency of fund fees for investors, but now the issue of ending trailer fees altogether is on their radar. Why wouldn’t it be, as other major countries have already adopted fundamental changes designed to protect mutual fund investors. Leading the way are the United Kingdom and Australia, which have banned adviser commissions set by financial product providers or embedded in financial products.

Bear in mind, too, that it’s not just the hidden cost of embedded commissions that makes Canada’s current fee structure system so ripe for criticism. Embedded or not, commissioned advice by its very nature constitutes an inherent conflict of interest. Ken Kivenko, of the Small Investor Protection Association, is no shrinking violet when it comes to airing his grievances about this issue. “Trailer commissions create the perfect misalignment of advisers incentives with investors’ best interests,” he writes on his website CanadianFundWatch.com.

Kivenko draws a colourful analogy between what he calls “adviser misbehaviour” and fast food servers who try to super-size your meal order. In the case of cashiers who pressure you to order fries or a larger beverage, they’re basically encouraging you to do something that lines their cash register with more of your money at the cost of your health. Likewise, Kivenko says, advisers work within a system that encourages them to sell you the most expense mutual fund products on the market because they’ll get a larger commission fee in return; in short, compensation drives advice, and investors are getting short-changed and their portfolios are suffering as a result.

Forget any arguments you may hear about funds with higher fees providing better results. It’s not true. In a recent report, Morningstar director of research Russel Kinnel was explicit on this point: “In every single time period and data point tested, low-cost funds beat high-cost funds.” Basically, higher fees just eat away more of your savings.

The Investment Funds Institute of Canada (IFIC), the voice of Canada’s investment funds industry, doesn’t want to see trailers done away with. Their chief argument in favour of keeping them is that people with smaller accounts would otherwise not have access to the professional services of a fee-based adviser. Advocis, the Financial Advisers Association of Canada, has touted a similar line, saying we would have a huge number of Canadians that would not be receiving the financial advice they need if trailers suddenly disappeared.

There’s certainly no arguing that lots of retail investors are getting financial advice these days and that the vast majority of that advice is paid for through commissions that are embedded in the cost of products. At the end of 2011, according to the CSA, the mutual fund industry managed $762 billion in assets on behalf of Canada, accounting for 73.8% of all Canadian investment fund industry assets under management. Of these mutual fund assets, 91% were acquired and held by investors through advisers, and over 80% of mutual fund investors said their last purchase was made through an adviser.

Like the Small Investor Protection Association, Paul Bates, chair of the Ontario Securities Commission’s Investor Advisory Panel, wants to see trailers banned. To critics who say the mutual fund industry would be devastated by changes to the embedded fee structure, Bates confidently asserts that entrepreneurs will simply fill in any gap in the market.

As it stands, though, Canadians already have lots of options for buying commission-free mutual funds—either as a DIY investor, or through low-fee mutual fund companies like Steadyhand or Mawer (to name but a couple). Retail investors have choices, and even if the industry is slow or unwilling to change, an educated investor can avoid trailers and keep more of their returns.

15 comments on “Investors don’t have to wait for Canada to bury trailers

  1. I think that it's the mutual fund *industry* that might be devastated by banning embedded fees, which is why they're the ones howling. Present the case to the people with smaller accounts who Advocis thinks will suffer along with the industry, explain to them that their advisor has been selling them high fee funds because they as consumers didn't know to question why, and I think you'll find that those regular people will be quite happy to invest in low cost index funds or ETFs with the help of a fee only planner, or learn to do it themselves. It's not rocket science.

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  2. I remember working at a big bank and discussing the annual changes to compensation with a manager. They would change the compensation to drive product sales, pure and simple. Want more of Fund X sold, raise the comp. Less of Money Market Y product, lower the comp. This worked like a charm. Salespeople are driven by compensation, pure and simple. We must remove embedded commissions and compensate advice with a separate, transparent and disclosed fee.

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    • Banks love to say that their advisors are paid a salary and therefore as pure as driven snow when it comes to bias and incentives, but it's just not true. I remember the same thing you do, Neil, and the constant pressure to sell the packaged portfolio funds with the 2.4% MERs was numbing.

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  3. The mutual fund fee issue is a 'Red Herring'.

    Most Canadians know by now that mutual funds have costs and those costs are summarized as an annual percentage (MER).

    The discussion is too narrow – those advisors selling Fee-For-Service accounts should be included in the discussion (and any subsequent regulatory changes).

    For investors – what is the difference between a mutual fund with a annual MER cost of 2.0% and a Fee-For-Service account that charges an annual fee of 2.0%???

    The advisor still gets their 'Trailer' Fee/commission – regardless of the level of service, expertise, or skill displayed.

    The investor still over pays. (In fact, I would argue Fee-For-Service accounts are worse, than mutual funds, for investors. Those advisors using Fee-For_Service accounts charged a single (blanket) fee based on the accounts' $ value, regardless how much is invested in cash, bonds or GICs. Outrageous!)

    Maybe someone can answer this question – Why do investment advisors charge Fees based upon % of an investors savings? (Answer – because they can!)
    Our Accountant doesn't charge us a % of my annual Gross Income.
    Our Lawyer doesn't charge us a % of the value of the assets they are dealing with.
    So why does an investment advisor feel their compensation should be calculated on our total savings – each and every year?

    P.S. – It is time more Canadians became their own advisor. For example, if you have $50,000 in savings, assume a 2.0% MER/Fee-For-Service cost or $1,000.00 would be your approximate savings to shift to DIY investing. Pay yourself $30.00/hour to learn, monitor and manage your investments. Budget $400/year for subscriptions to solid independent investment publications, courses and research info. In 5 years you would be making better financial decisions with greater confidence and success. (The $30/hour you should actually take and use as a reward – dinners, travel, etc.)

    What that age old saying – "Pay Yourself First".

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    • What are your recommendations for solid independent investment publications, e.g. Money Sense, courses and research info? I am interested to know. Thanks.

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      • Hi, Hyne
        For investing:
        Courses: I would think a person could start by learning the basics through the Canadian Securities Institute. Their CSC course would be a great starter. They provide the training for the investment industry and all of their courses are available to DIY investors. (https://www.csi.ca/student/en_ca/courses/csi/csc.xhtml?icid=LNK-CSICSC–I05#tabview=tab1)

        Publications: You already read MoneySense, but I think another great service for DIYers would be a subscription to The Investment Reporter and The Blue Book. Both created and distributed by MPL Communications. The Investment Reporter is one of Canada's longest running and most successful publications – established in 1941. (http://www.investmentreporter.com/) Both of these are paper based subscriptions. MPL also offers an online publication "Advise For Investors" (http://www.adviceforinvestors.com/) They also have sister publications for mutual funds and exchange traded funds.

        Website Education Resources: There are some great website resources like Investopedia (which is American, but their basic investing videos, articles and research is just as applicable for Canadians). Other websites are ETF Sage, ETF Insights, StockRover, Canadian ETF Watch, ValueLine (which is American, but they provide free research for the Dow 30 companies which is great (http://www.valueline.com/dow30/)), etc. There are just too many to list.
        Hope this is of some help.

        Regards

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      • Hi Hyne,

        I would recommend MoneySense's "Guide to the Perfect Portfolio": http://www.moneysense.ca/2011/11/29/moneysense-gu

        Also, be sure to read my new article on using mutual funds wisely in the Summer issue of MoneySense, which is just hitting newsstands.

        Thanks,
        David

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  4. I remember an idea from "Investing for dummies" – that 90% of the so-called "advisers" are, in reality, simple sales-people. This was the opinion of one of them. Without blaming ALL advisers – I am sure there are smart and good people among them – In my experience with an Edward Jones "adviser", it is a true statement. My "adviser" when asked how much I would be charged for early redemption said he doesn't have a clue and I should ask the secretary. He would suggest me a fund only when I would ask him and then his arguments to my question "Why this?" would be "I made lots of money with it". My ex-spouse went to see another "adviser" from Freedom55 and, after asking a number of pertinent questions about MER, expressing preference for some funds, got the "adviser" so excited that she asked "You are so informed! Would you consider a position with us?" I think it's unfair when an "adviser" makes money when their client is losing money – that is why 2/20 system is better (I would use it with a tested person if I wasn't doing it myself).

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  5. Our government is concerned that Canadians will not be able to save enough to retire comfortably. Retirees fear they will run out of money. In this low market returns environment, the mutual fund industry is siphoning about 50% of the investors returns. Isn't time ouir governement steps in to protect it's citizen against this very obscure industry who refuses to disclose too much information to their poorly informed and trusting clients. My suggestion: never deal with an advisor who is paid compensations, too many opportunities for biases; all advisors to have fiduciary obligations to their clients; have all fees paid to the mutual fund companies and to the advisor fully transparent and included in the investment statements; have the advisor report all the services he has provided; provide basic financial litteracy education to investors by people who are independent from the investment industry. .

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    • I think the key here is freedom of choice and transparency. The CSA has taken initiatives to improve transparency by highlighting the fees paid to the advisor. The client then has the choice to shop for other solutions whether that is managing the funds themselves or moving to an annual fee model. If the CSA decides to remove the client’s freedom to decide between embedded fee structures or an annual fee model, it will undoubtedly have the reverse effect than their intentions. It can be argued that the higher net worth clients with large balances are helping support the lower networth clients as their embedded commission percentage is a higher dollar amount. By charging a level fee, client’s with low balances will likely have to find lower quality services or manage their financial plan themselves. With the high costs of regulation and running an office, clients with smaller balances will likely be unwilling to pay the higher annual fee to keep the relationship profitable for the advisor. For example, if it will cost an advisor $1,000 per year to maintain a relationship with a client and provide financial advice, yet the client’s portfolio is only worth $20,000, they will likely not proceed as any earnings on the fund will not be worth the cost of advice. To say that banning commissions is in the best interest of the little guy goes against logic and common sense. I would rather argue that if the higher networth clients are willing to continue with this model and support the little guy, they should have the freedom of choice to do so, so long as they are aware of the costs to them. Luckily, the CSA and Advocis have taken the necessary steps to make this so.

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  6. If you want to see the effect of these MERs on your investments, try applying the "Rule of Forty"!
    The Ro40 states that to determine how many years it will take for the MER expenses to reduce your invested capital by 1/3, divide your MER percentage into 40. ie, if the Mer is 2%, the capital will be reduce by one third in 40/2=20 years. If it is 2.5%, it will be gone in only 16 years. This shows you in a very practical way just how big a drain these excessively high Canadian MERs have on your investments! Next time you are at an "Information" Seminar, put up your hand and ask the speaker to explain the rule of 40 to the group. Watch them squirm, if they know it (most do not), and offer to explain it to the group if they decline to do so!

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  7. Hi Gary,
    There are so many things wrong with your points above. Simply answer this : What amount in dollars would a person lose to fees and opportunity costs if they invested in funds with you with an MER of 2.5% over 25 years – regularly and invested enough to have a million $ portfoilio upon retiring…. I will tell you. The fees would be somewhere in the range of $350,000.00. How can anyone justify that amount. It's totally absurd.

    Most people would simply be better off regularly investing in the investment companies themselves that offer the funds than the funds offered by them.

    The industry needs to become more fair with their fees. Fringe investment companies need to be brought under control as well. I recently read that seg funds (most company pension plans) don't have the same disclosure rules and won't be included in the upcoming changes to the way statements show fee's next year. If your proud of your achievements for your clients why would you hide the numbers deliberately?

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  8. Some times it is not possible to solve every problem with money. Useful blog for investors.

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