PETER DOLEZAL: Demystifying the mutual fund industry

Do you have mutual funds in your investment portfolio? Are you aware of the total fees that holding such funds incurs?

Do you have mutual funds in your investment portfolio? Are you aware of the total fees that holding such funds incurs?

Many investors know that a Management Expense Ratio (MER) is charged. Few however, know the actual amount. Since this averages well over two per cent of the holding across some 3,500 Canadian mutual funds, it is a cost well-worth noting, and if possible, minimizing.

Very few mutual fund holders are aware that their adviser receives an ongoing trailer fee, amounting to one third or more of the MER charge. This can amount to hundreds, and even thousands, of dollars annually in direct payments to the adviser, for as long as the client remains invested in the mutual fund account. In 2011, the Canadian Securities Administrators organization in fact determined that the average adviser receives some 64 per cent of his/her total compensation from trailer fees.

While the average adviser may hold various professional designations which encourage  putting a client’s interest ahead of their own, the fact remains that their incentive is huge to sell a mutual fund, rather than for example, an Exchange-Traded Fund (ETF) or an Index fund, at one quarter or less than the average mutual fund’s ongoing cost.

Because mutual funds promote their goal of beating their comparable indexes, it is not unusual for a mutual fund to experience a 100 per cent turnover annually, in dollar terms.

The significance is that each buy and sell within the fund results in a trading cost, again passed on to the fund, over and above the MER charge. As a result of this “churning” of holdings, capital gains can be incurred, with the resulting tax consequence passed on to the client.

Even assuming no additional “front-end” or “back-end” load fees, it is not unusual, with all of these costs, for a client’s average mutual fund to cost between 2.5 and three per cent of invested value annually. It is due precisely to these high fees that no more than 20 per cent of Canada’s mutual funds beat their respective index in any given year. In effect, the industry is feasting on its clients’ ignorance of the real effect of mutual fund fees on long-term returns.

Canadian securities regulators are intent on bringing greater transparency and understanding of the various fees charged to clients. So far however, the level of effective disclosure remains abysmal.

If urged by an adviser to invest in a mutual fund, a client should request a) a succinct written summary of every fee – visible or hidden — including the ongoing trailer fee the adviser would receive; and b) a concise historical performance record of the recommended mutual, not only against its peers — with their similar fees and therefore, generally lackluster performance, but also against the most comparable index.

An adviser is entitled to receive compensation for advisory services provided. However, all costs should not only be made very clear to the client, but also justified by superior long-term performance of the products recommended.

As it stands now, the mutual fund industry has created a compensation structure for advisers that has turned them into their sales arm, thus undermining the adviser’s incentive to put the client’s best interests ahead of his/her own.

The time for change is long overdue. Hopefully, Canadian securities regulators will persevere and do what is right for the Canadian investor.

Drastic change is needed to shift the balance of benefit away from the mutual fund industry and its adviser sales team — to the client.

A retired corporate executive, enjoying post-retirement as an independent financial consultant, Peter Dolezal is the author of three books, including his most recent – The SMART CANADIAN WEALTH-BUILDER.