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Louis Lowenstein’s book The Investor's Dilemma (2008) excoriates the U.S. mutual-fund industry, describing a variety of now familiar complaints. Its recent publication raises once again the issue of whether or not investors should avoid mutual funds.
It may seem exploitive to charge 2.5% or so in annual management expenses in Canada when all a mutual fund can hope to do is provide the same return as the market. It is better, argue the critics, to buy stocks or exchange-traded funds and obtain the market return with lower fees.
But could critics of mutual funds be overlooking a few important facts? One is that high mutual-fund fees, in many cases, are a price paid not just for the fund itself but also a bundle of ancillary financial services.
The financial advisors who sell mutual funds typically package them with financial advice on taxes, estate planning, RRSPs, RESPs, portfolio diversification, and a host of other aspects related to personal finances. Ostensibly, this advice is offered for free but payment occurs indirectly through mutual-fund fees rebated back to the advisor (i.e. sales commissions and/or trailer fees).
Winnipeg-based Investor’s Group is one company that has gotten very good at offering financial-planning services. They may primarily be a mutual-fund marketing organization, but they also show investors how to reduce their taxes, pass on assets to heirs, arrange for powers of attorney, set up trusts, obtain insurance, invest for children’s post-secondary education, create diversified portfolios, and so on.
For example, experienced financial planners can show clients several ways to avoid probate fees that come due on their estates when they die. The options include arranging to own assets under joint tenancy, designating a beneficiary on an RRSP, insurance policy, etc., and setting up a trust.
There are indeed a lot of nooks and crannies to mine in the personal financial realm. To see how extensive they are, check out the list of articles provided by Tim Niblett of Milton, Ont.-based Donaldson Niblett Financial Group.
A second possible explanation for mutual-fund fees may be “time preference.” Mutual-fund investors don’t have to pay up front for financial-planning services. They can pay when they sell a fund (rear load) and/or through annual management expense ratios. This might be a convenience for which people are willing to pay extra — just like they are willing to pay interest on loans taken out to purchase cars, houses, etc.
A third possible explanation for mutual-fund fees is the “trust premium.” Handing one’s money over to someone else is something that makes many investors apprehensive and they may be willing to pay a little extra if the financial advisor is a relative, friend, or otherwise a person they feel they can trust — as is often the case when they become a client of a financial-planning firm.
Don’t get me wrong. I’m not offering a defense of the mutual-fund industry. As an economist, I am always curious about how markets work — in this case why mutual-fund fees are widely criticized for being too high yet the fund industry continues to thrive. The explanation, in part at least, appears to be the value added through ancillary financial services, time-preference, and the trust premium.
Exploitation exists when there are no choices in the market. That is not the case here. Investors can buy individual stocks, index funds, exchange-traded funds, and mutual funds that keep costs low by dispensing with advertising and marketing.
Do-it-yourself investors don’t mind investing the time and energy required to research their own investments and personal finance questions. However, not everyone has the same appetite for digging into their personal finances (e.g. those busy with job and family). Financial planners can spare the latter group the “search” costs while catering to “time-preferences” in transactions and “trust premiums” in financial dealings.
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