All the ingredients are in place for a battle that could shake the mutual funds industry to its roots and open the way to lower costs for investors.
The recent release of an in-depth study of the impact of trailer fees on costs and returns appears to have drawn a line in the sand between regulators and consumers on one side and the advisory community on the other.
The report, awkwardly titled A Dissection of Mutual Fund Fees, Flows, and Performance, was prepared by three business school professors, led by Prof. Douglas Cumming, Ontario Research Chair at York University's Schulich School of Business. It was commissioned by the Canadian Securities Administrators, which is made up of the provincial and territorial securities commissions across Canada.
The report concluded that there is a clear connection between the commissions that a fund pays out and the amount of new investment money that flows in. As a general rule, the researchers found that trailer fees rather than performance appeared to influence the purchase recommendations of a significant number of financial advisers. Trailer fees are paid annually to advisers by the fund companies to compensate them for their service to clients.
The study also found that an increase in trailer fees resulted in a decrease in performance and vice versa and that funds sold through affiliated dealers tend to perform worse than those sold by independent advisers.
Predictably, investor advocate groups immediately called for the abolition of trailer fees on mutual funds, as was done in Great Britain a few years ago.
"It's time for the research to be translated into reforms – either by adoption of a best-interests standard or at least by banning trailing commissions," The Globe and Mail quoted Neil Gross, executive director of FAIR Canada, as saying. (FAIR is an acronym for the Canadian Foundation for Advancement of Investor Rights.)
The adviser community fired back, claiming that investors are content with the current system and warning that banning trailers would price financial advice out of the reach of many people.
"Upon preliminary review, it appears that the report does not consider the monetary value of the financial advice provided to clients," said Greg Pollock, CEO of Advocis, The Financial Advisors Association of Canada.
"Our anecdotal evidence tells us that Canadians are generally satisfied with the current commission system for mutual funds. There's a cost associated with advice regardless of how it is paid. Not every Canadian can afford to pay an upfront fee for service, which can be several hundred dollars an hour."
The issue is an important one. The mutual fund industry has over $1 trillion in assets under management and the great majority of those funds carry trailers. Those fees reduce returns.
To illustrate the impact, let's look at CI's Cambridge High Income Fund, which is one that I have recommended in my newsletters. The A units of the fund, which are sold to the general public, have a management fee of 1.9 per cent. The F units, which are available only to fee-based accounts, have a 0.9 per cent fee. The 1 per cent difference represents the trailer, which is paid every year to advisers as long as the client owns the fund units. It's a prime source of adviser income; for every million dollars of fund units on the books, an adviser receives $10,000 a year. Some funds pay even higher trailers, up to 1.5 per cent, in an effort to attract more business.
Higher trailers translate directly into lower returns. The A units of Cambridge Growth showed a 10-year average annual compound rate of return of 6.72 per cent as of Sept. 30. So $10,000 invested a decade ago would have been worth $19,163 at that point.
The F units, by contrast, had an average annual return of 7.84 per cent over the period. The same $10,000 invested in those units would have been worth $21,272 on Sept. 30. That's $2,109 more than the value of the A units, an improvement of 11 per cent.
Of course, holders of the F units had to pay a fee to the adviser, which probably offset most or all of the improved return. If the advice received was beneficial, the cost was worth it.
But if the two-tier structure were eliminated, the whole dynamic of the investor-adviser relationship would change. A world free of trailer fees would give do-it-yourself investors access to the equivalent of F units without paying an adviser fee. Those who want advice would be able to negotiate a fee based on the degree of service required, rather than automatically having a charge levied against their fund returns.
This debate is going to take time to play out so don't expect dramatic changes any time soon. But based on the report, it seems clear the regulators have trailer fees directly in their sights.
Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters.
Gordon Pape