“According to the CSA, mutual funds are the most commonly held investment product in Canada, with 62% of all Canadian investors holding mutual funds in their investment portfolios. Most of these investors purchased their mutual funds through an advisor.”
The Canadian Securities Administrators (“CSA”) recently released a discussion paper and request for comment regarding mutual fund fees. The paper examined the various fees that are paid to advisors for selling mutual funds to investors. There is a perception that fund fees are relatively high in Canada. The paper has precipitated a great deal of discussion within the fund industry, and coverage by the mass media about fund fees.
The paper attempts to clarify (if that is possible) the different types of commissions and compensation structures used by different classes of mutual funds. The paper raises some interesting points regarding the alignment of an advisor’s interests with the interests of their clients, as the advisor may prefer to have the investor purchase units that result in higher compensation for the advisor at the cost of the investor’s overall return.
According to the CSA, mutual funds are the most commonly held investment product in Canada, with 62% of all Canadian investors holding mutual funds in their investment portfolios. Most of these investors purchased their mutual funds through an advisor. Investors typically incur two types of expenses when investing in mutual funds: sales charges and ongoing fund fees. Investors pay a sales charge either when they purchase a mutual fund, or redeem their units of the fund. Ongoing fund fees are made up of management fees (paid to the manager of the fund, even if the fund loses money) and fund expenses (legal fees, accounting fees etc.). These fees are paid from the assets of the fund and are thus indirectly borne by investors.
When mutual funds became popular in the 1980s, most investors paid a transaction based sales commission when the purchased the fund; this is known as “front-end load”. In the late 1980s, deferred sales charges or “DSC” funds (also called “back-end load”), were introduced. In a back-end load, the fund manager pays the dealer the commission at the time of sale, and the investor may pay a redemption fee which declines over the life of the holding. The amount of the redemption fee generally declines over time to nil, depending on how long the fund is held. A “low-load” sales charge is similar to a back-end load, but the redemption schedule is shorter, allowing the investor to exit the fund earlier without paying a fee. “No-load” mutual funds also exist. These funds do not pay any sales commission, nor is there any fee when the investor redeems them. These no-load funds are generally purchased directly from the mutual fund manufacturer. “Series F” mutual funds are intended to be purchased by an investor with a fee based account with their advisor. Since the advisor is being paid by the investor, these funds do not charge anything for buying or exiting the fund. Further, the management fees of series F units are generally lower as there is no embedded trailing commission that is paid.
The paper examines several trends in the mutual fund industry including: a) downward trend of management expense ratios; b) upward trend of trailing commissions and c) increased reliance of advisors on trailing commissions as a revenue source.
The CSA notes several issues that arise from the current mutual fund structure in Canada. These issues include:
- Lack of investor understanding of fund costs and control of advisor compensation;
- Potential conflicts of interest at the mutual fund manufacturer and advisor levels;
- Potential for cross-subsidization of commission costs associated with a fund (depending on the purchase option); and
- Alignment of investor compensation and the services provided by advisors.
The paper examines regulatory reform underway in the UK, Australia, the US and Europe, as well as some regulatory initiatives in Canada and quotes several studies that conclude that Canadian mutual fund fees are among the highest in the world. Ultimately, absent new regulation of fees, only greater transparency of fund fees and investor knowledge might cause investors to shop around and provide downward market pressure on fees. The CSA propose several new regulatory initiatives and invite feedback from market participants. The new proposals are:
- Advisor services to be specified and provided in exchange for trailing commissions;
- A standard class of fund for DIY investors with no or reduced trailing commissions;
- Trailing commission component of management fees to be unbundled and charged/disclosed as a separate asset-based fee;
- A separate series or class of funds for each purchase option;
- A cap on commissions;
- Implementation of additional standards or duties for advisors; and
- Discontinue the practice of advisor compensation being set by mutual fund manufacturers.
As mentioned, the CSA is seeking feedback on these proposals from interested parties who may submit comments until April 12, 2013. Read the full paper, including instructions for providing comments. Even if no regulatory reform is forthcoming, hopefully the paper resulted in a greater understanding of fund fees and advisor compensation to allow investors to make informed investment decisions.