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Deferred sales charge funds are sort of like a Chinese finger trap: it's easy to get into them, but much harder to get out.
The biggest complaint I hear from prospective clients occurs when they realize that their investments are essentially locked in by deferred sales charges (DSC). Many of these investors do not know about DSCs and the frustration from these individuals is palpable.
I don't blame them. From an investor perspective, I see no redeeming value in owning a fund with a DSC.
What's a DSC?
The DSC is a fee that gets charged to a client (usually starting at about 5 per cent or 6 per cent in year one, and declining to 0 per cent after 6 or 7 years) if they sell a mutual fund and don't transfer the funds to another mutual fund from the same company.
How it started
Some innovative Canadian mutual fund executives came to the realization that if you pay a stock broker or mutual fund salesperson a lot of money up front, they are more likely to sell your product. In most cases, a 5-per-cent fee is paid to the broker. This 5 per cent is usually split in some way with the broker's company, in addition to an ongoing payment to the broker of about 0.5 per cent a year. On the other hand, for selling a no-load fund, an adviser would receive roughly 1 per cent a year.
Mutual fund companies often sold limited partnerships to raise the money so that they could afford to pay the broker the up front funds.
It's a problem because if a client decides to move the assets out of the fund family, the mutual fund company needs to recover the commission already paid out. It does this by having the client pay the fee, which can be large if they leave the fund in the first few years. In many cases, clients keep their funds invested with the fund family solely to avoid paying this fee.
Many sellers of DSC funds claim the fee is positive as it keeps people invested. The truth is it's nonsense. If someone was afraid to be in the market in 2008, they simply would have moved their equity fund to a money market or bond fund. It doesn't keep the individual invested in the markets, only trapped with the fund company.
Investor solution
As a consumer, the solution is simple: Don't buy funds with a DSC. Ask the right questions, and be sure you are buying a fund on a low-load or no-load basis in order to keep your investment options open.
Industry solution
There are many steps that regulators could take. The best step would be to make the adviser pay the DSC if a client leaves early. By putting the adviser on the hook, you can be certain that far fewer of them would sell funds on a DSC basis.
Regulators can make all of the requirements for full disclosure and signatures that they want - and they should - but until you make the adviser pay, there will still be a strong incentive for stock brokers and mutual fund salespeople to say "show me the money up front," and sell mutual funds with a DSC.
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Ted Rechtshaffen