Why mutual funds are about to get cheaper to own in Canada

New regulations taking effect in 2017 will force fund managers and firms to disclose more about their fees. Investors may be surprised by how much they’re paying

 
Big hand of a regulator shifting scales with investors on them

(Illustration by Iker Ayestaran)

Mutual funds are still the most common way for Canadians to hold stocks and bonds, and the war over their fees and transparency is headed for a new battleground. This fall, the Canadian Securities Administrators (CSA) are expected to come out with groundbreaking rules that could change the way most investors receive financial advice. They will follow the lead of counterparts in Britain, Australia and the Netherlands and ban trailer fees and deferred sales charges (DSCs).

This is a significant step up from regulators’ previous efforts to improve the industry’s disclosure of hidden or hard-to-understand charges on their statements, and it could at last move the needle on fees. Christopher Davis, director of research at Morningstar Canada, expects it to reduce management expense ratios (MERs) by about one percentage point on average, which would bring them in line with fees charged in the United States. But doing so might also drive a lot of funds, managers and advisers out of the business. “This is the kind of change that would upset the structure of the industry,” Davis says.

A trailer fee is a commission a mutual fund company pays to an adviser for selling its funds. Deferred sales charge funds typically pay the adviser a large kickback up front—around 5% of assets— and a smaller trailer fee over the ensuing seven years, as long as the client stays invested. Should they sell out of the fund early, a pro-rated penalty is deducted from the principal to cover what’s already been paid out to the adviser. But this cost isn’t the main reason the CSA wants to ban these commission-based products, says Davis. The regulators want to eliminate conflict of interest.

For many years now, critics of trailer fees have been saying advisers are more likely to put clients into funds that offer attractive commissions over ones that don’t. If that’s the case, then what kind of advice are people really getting? “Some companies are incentivizing advisers to sell a certain group of funds over others,” says Davis. “The CSA is concerned about these potential conflicts.” The United States Department of Labor tackled this issue another way in April, by saddling advisers with fiduciary duty, meaning they must act in the best interests of their clients. If they don’t, they can be sued.

Regulators everywhere have reason to be concerned about conflicts. Last year, Douglas Cummings, a professor of finance at York University’s Schulich School of Business, published a report commissioned by the CSA on how fee structures affect fund sales. He found that funds with trailer fees are far more likely to experience positive inflows; the higher the trailer fee, the more probable it is to be sold, regardless of past performance. As well, when performance falls, people are much less likely to withdraw money from funds with DSCs (also known as back-end loads) and trailer fees.

These findings have a number of implications, Cummings notes. The top-performing funds may not be attracting the capital inflows they could be because advisers (and clients, if they face a redemption penalty) are less willing to sell an underperformer with an ample commission. Poor-returning funds are therefore insulated when they may be better off dead. Investors may also be getting subpar returns on their money. “The higher the trailer fee, the less incentive you have to generate performance,” says Davis.

Some investment companies are already taking action on fees. Last January, Sentry Investments cut its trailer fee from 1.25% to 1%, while Edward Jones Investments is no longer selling DSC funds. Other fund managers have simply reduced their management expense ratios. In February, RBC cut the MER on a number of its funds between 10 and 15 basis points.

These reductions aren’t happening for some altruistic reason. Companies are finally doing something because in early 2017, clients are going to find out exactly how much they’re paying in commissions, says Tom Bradley, president and co-founder of Steadyhand Investment Funds, a Vancouver-based firm that manages commission-free funds.

The Client Relationship Model, Phase 2, or CRM2, a new CSA rule that forces firms to disclose all fees on their statements, will wake many people up to the fact that they may be paying too much for too little, Bradley says. Trailer fees are supposed to cover the cost of financial advice, yet many clients don’t receive advice and don’t know they’re entitled to it. “While there are many advisers who collect trailer fees and do a nice job for clients, there are also too many abuses where there’s no service provided, even though there’s this ongoing fee,” he says.

Ultimately, the ban is about value, says Bradley—are investors getting what they’re paying for? He thinks fees may not actually fall as a result of these changes. If advisers can’t get their 1% commission, they’ll just move to a fee-based model, where they can charge 1% on an investor’s total assets.

However, investors and their advisers can reduce fees if they want to. Once free of DSC charges, they can move their money to mutual or exchange- traded funds with lower MERs. Bradley estimates that up to a million Canadian investors will switch advisers once the final phase of CRM2 comes into effect next year and trailers and back-end loads are banned.

Investors need to keep in mind that more freedom to move around shouldn’t necessarily lead them to jump in and out of funds. There’s plenty of research to suggest that switching too often can hurt performance—investors can miss an upswing or fail to let their money compound. There’s also a risk that bad advisers will make trades to appear as if they’re doing something in order to justify their fees, says Davis. Most are expected to rely less on fund sales, though.

People should be careful about leaving a DSC fund they already own as well. These funds could take time to wind up, says Bradley, and if you leave too early, you may still get charged a big fee. Like breaking a mortgage, however, it could make sense to take the hit, depending on how many years you’ve already held the fund and the advantages of the alternatives.

Even if investors don’t save a whole lot, they will be much better off when trailer fees disappear, says Cummings. It will be easier to understand who’s getting what, there will be more choice and advisers won’t be beholden to the fund companies that pay up. “There will be fewer conflicts of interest,” he says. “If a fund is performing poorly, you’ll be able to do something about it.”


MORE ABOUT INVESTING & MUTUAL FUNDS:

Get our daily briefing on innovation, leadership, technology & the economy.
Weekdays at 6 AM ET. Learn More »

Comments are closed.