It's no secret that Canadian mutual fund fees are among the highest in the developed world. What many investors may not know is that despite industry claims that fees are coming down, the cost of paying advisers who sell the funds has crept up significantly.
Over the past two decades the way fund companies compensate advisers has shifted from one-time-only loads when they are bought or sold, to hidden trailer fees every year.
"The industry has found a way to make people pay more," says Christopher Davis, director of manager research at Morningstar Canada. "Investors are basically paying every single day they're in that fund with a trailing commission."
In the past, advisers drew their compensation primarily from "loads" based on a percentage of the amount a client invested in a fund. A "front-end load" is charged when the fund is purchased. A "back-end load" is charged when the fund is sold and normally declines over time. Many fund companies allow the investor to choose between them with what is call an "optional load."
As additional compensation, advisers can collect an annual trailer fee embedded in the fund's management expense ratio, or MER. (The MER is also based on a percentage of the amount invested in a fund but is paid each year to compensate the mutual fund company for marketing, administration and to pay the fund managers.)
While fund companies are required to disclose the MER, the trailer fee portion can remain hidden within it.
In the 1990s, annual trailer fees amounted to about half of 1 per cent for an equity fund, and a quarter of 1 per cent for a fixed income fund.
Responding to pressure from investor advocates, many fund companies have lowered or dropped their loads altogether. At the same time the typical trailer fee has doubled to 1 per cent for an equity fund and half of 1 per cent for a fixed income fund. Instead of one payday the adviser collects a stream of compensation based on the amount invested no matter how the fund performs.
"It affects the performance every single minute you're in the fund. Basically the mutual fund company and your adviser are skimming 1 per cent off the top of your investment," Mr. Davis says.
To illustrate how trailer fees can sap retirement savings, imagine an investor builds a comfortable portfolio of mutual funds worth $1-million. A 1-per-cent trailer fee would take $10,000 from the nest egg each year and put it in the pockets of the advisers even if it was bought years ago. Over the course of an investor's life trailer fees could easily exceed $100,000.
In addition, one-time loads on some funds are as high as 6 per cent. Mr. Davis says it's difficult to know how they affect performance because loads are imposed at the discretion of advisers, who often use them as a negotiating tool to sell funds.
"Loads are negotiable. You don't know whether people are paying them. Most of the time no one is paying the load," he says.
Mutual fund investors who actually pay loads may be surprised to learn that even the industry doesn't expect them to get stuck paying. "Virtually all the payment for the adviser is in the trailer fee, and most of the front-end loads are not charged at all," says Jon Cockerline, director of research at the Investment Funds Institute of Canada. IFIC represents 150 mutual fund managers, dealers and other investment businesses.
Mr. Cockerline admits the push from loads to trailer fees generates more money for the adviser but says it gives a greater incentive to provide service beyond the point of sale. "The whole process of advice is very labour intensive and front-ended."
Although decisions relating to the actual fund and its holdings are made by a portfolio manager with the fund company, he says advisers can provide personalized service by getting to know the client's long-term objectives and risk tolerance.
"It is a way of aligning the clients' and advisers' interest. The adviser likes to see his client's assets grow and this gives an incentive for that to happen."
Mr. Cockerline also cites a recent study by the Center for Interuniversity Research and Analysis of Organizations (CIRANO) that finds households receiving financial advice for at least four years accumulate more than 1.5 times more assets than those who do not have an adviser. After 15 years or more with a financial adviser, households accumulate more than 2.7 times more assets, according to the study.
"It's not as much a question of performance as it is the accumulation of savings – the discipline of saving, the savings culture so to speak. It's a difficult thing to learn," he says. "Something as simple as a preauthorized deposit yields huge benefits over a person's lifetime."
He says streamlining trailer fees across the industry also removes the temptation for advisers to recommend the fund with the highest payout instead of the best fund for the client.
"The industry has matured to a point where there is a standard in the marketplace for these trailers," he says. "Regardless of what fund company you're selling, you're getting the same trailer fee."
IFIC is currently part of an initiative led by the Ontario Securities Commission to better explain the mutual-fund fee structure to investors. Changes are expected to be implemented in July of 2016.