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portfolio strategy

F-class mutual funds are relatively cheap, but investors who have financial advisers can still do better.

Now that the cost of do-it-yourself investing has been pounded almost into the ground, we need to do something about people who have advisers.

A DIY investor can build a simple but effective portfolio of exchange-traded funds with commission costs of $10 down to nothing per transaction, and only a tiny cost of ownership. In a fee-based advisory account, the cost of advice and trades comes in roughly between 1 and 2 per cent. On top of that, you have to add the fees associated with owning particular investments.

A basic rule of investing is that lower costs feed higher returns. If you're the sort of investor who is best served by having an adviser, the most practical way to follow this rule is to squeeze the costs of the products you own as low as possible. Advisory fees vary, but insisting on the cheapest makes no sense. Value in terms of services provided is important, too.

The same cheap ETFs that DIY investors use would be a great fit for a fee-based account. But a lot of advisers are choosing F-class mutual funds, a special type of mutual fund designed for fee-based accounts. F-class funds cost a lot less than regular mutual funds, but they're nowhere near the bargain that ETFs are.

The ETF company Vanguard jumps all over the price discrepancy between F-class mutual funds and ETFs in an advertisement it's running in investment industry publications to get the attention of fee-based advisers. The ad shows the difference between having ETFs and F-class mutual funds in a fee-based account could be 1.12 percentage points, enough to generate an extra $123,078 in returns over 20 years for a sample $250,000 investment.

"Part of running the ad is the education aspect," said Atul Tiwari, managing director, Vanguard Investments Canada Inc. "It really doesn't make a lot of sense in the fee-based model to use a higher-cost vehicle."

Vanguard's ad is notable because it suggests advisers do right by their clients when they keep fees low. That's a message that isn't heard enough. The ad also shows that Canada's investing industry is starting to prepare for the possibility that regulators will decide to ban trailing commissions, which are how advisers who sell mutual funds and don't use fee-based accounts are paid. Trailers are embedded in the cost of owning a fund and paid directly by fund companies to advisers. Regulators have been considering a ban on them for a couple of years now.

Fee-based accounts are more transparent for investors and reduce the potential for conflicts in which advisers recommend funds that pay the best trailers. Advisers benefit by having a more professional relationship with clients that is based on providing advice and being paid directly for it. An important – but not much talked about – aspect of a move to fee-based advice is which investments are the best fit for this advice format.

Vanguard's ETF-mutual funds comparison started with an advice fee of 1.25 per cent, which is on the low side if you don't have an account that is well into six figures. The company's own research on costs in fee-based accounts shows a range of well below 1 per cent for very large accounts to 2 per cent for accounts on the small side.

On top of that advice fee is an average management expense ratio of 1.36 per cent for F-class mutual funds. Once again, just to be clear, F-class funds are cheaper than regular mutual funds because they have embedded compensation for advisers (trailing commissions) removed. These commissions are redundant in a fee-based account, where you pay your adviser directly.

Vanguard used an industry-wide average MER for F-class funds, which may overstate things just a bit because smaller funds tend to have high fees. The Investment Funds Institute of Canada says that if you used asset-weighted numbers – they put more emphasis on bigger funds – you would get an MER of 1.03 per cent. Given how advice fees become more economical for large accounts, IFIC said in an e-mail that "the F-series would be most relevant for clients with a higher level of investable assets than the average investor."

The average MER for 16 of Vanguard's more established funds is 0.24 per cent. Other ETF firms would likely have higher average fees for their products, but most offer enough low-cost options to get somewhere close to 0.24 per cent. The point is, this isn't a contrived number that exists only on paper.

Combine the 1.25-per-cent advice fee with the average F-class mutual fund MER and you have an all-in cost of 2.61 per cent; with ETFs, the all-in cost is 1.49 per cent, or 1.12 points less.

Vanguard's estimate of how much more its sample, fee-based ETF portfolio of $250,000 generates is based on growth at 6 per cent annually before fees. The obvious objection here is that F-class funds have the potential to outperform ETFs. An ETF typically tracks a stock or bond index, while mutual funds are run by managers who pick their own securities and thus could do better than the indexes.

Problem is, the higher fees of mutual funds weigh down returns. That's why mutual funds often fail to match the returns of index-tracking investments ETFs on a consistent basis.

Data from the analysis firm Investor Economics show that 2013 growth in assets for ETFs and mutual funds held in fee-based programs at full-service brokerage firms has been roughly similar – 21 per cent for funds and 23 per cent for ETFs in 2013. There was about $20-billion in ETF assets held in fee-based programs at Dec. 31, compared with $55-billion in F-class funds.

If Vanguard's experience in the United States is any indication, ETFs will be an increasingly popular choice with fee-based advisers here. "Growth in our adviser business in the U.S. has gone from virtually nothing 15 years ago to by far the fastest growing part of Vanguard," said Jason McIntyre, head of distribution at Vanguard Canada.

Investors, you can help this process along. If you have a fee-based account, have a chat with your adviser about the kinds of investments being used. F-class funds may have a role in your portfolio, but ETFs are the cost-conscious choice.

Globe app users please click here for a chart from Vanguard comparing ETFs and F-class mutual funds in a fee-based advisory account