Everywhere you turn these days, investors and pundits are grumbling about the high costs of mutual funds. Paying 2.5 per cent wasn't so bad when markets were up 20 per cent. But when they're down, and when their returns are reverting to the long-term mean of high-single-digit growth, that becomes a bigger and bigger chunk of investor returns.
The fund companies typically bear the brunt of the resentment, and there are plenty of people wondering when management expense ratios (MERs) are going to fall. It's a good question but it should be directed at financial planners more than mutual fund companies. Contrary to conventional wisdom, planners have a big say in pricing, even if they don't get any heat over it.
Canadian mutual fund investors tend to be apathetic and dependent. They prefer to do business with a planner on the belief that they're getting impartial third-party advice. They also don't think very much about the consequences of some of their decisions. When they get short-changed by the financial services community, in other words, they bring it on themselves.
If you want to understand how to maximize value as a mutual fund investor, it helps to see where the interests of the various players lie. It helps to understand that financial planners have interests that can be in stark contrast to yours. Apathy and ignorance, you'll find, are costly.
Here's an example. You bought a back-end load fund from a planner several years ago. At the time of sale, the planner got an up-front fee from the company for selling it to you, typically 5 per cent of the investment.
Those up-front fees can add up to a lot of cash if back-end load sales are brisk. Some fund companies have the wherewithal to finance this expense themselves, while others turn to an outside source. At any rate, this is how the MER typically breaks down.
Let's say the expenses are 2.5 per cent of the fund. Fifty basis points (0.5 per cent) are used to pay for auditing, regulatory and legal expenses. Seventy basis points goes to finance the up-front fee, 50 points goes to the planner or planner and 80 points go to the fund company.
If you pull out of the fund before you're clear of the back-end load -- typically after seven or eight years -- you pay a penalty, which goes to whoever financed the up-front fee. Your planner will be hard-pressed to advise you to sell before you're free of the penalty. But once you are, he's likely to give you a call.
If your fund was a dog, it might be to encourage you to buy another fund, maybe another back-end load with an up-front fee to the planner. Otherwise, it might be to tell you there's going to be a "bookkeeping" change in your account as he moves you from the load to the no-load variety of the same fund.
Why? Because the minute that back-end load fund is sold, the investor -- you -- no longer has to fund that up-front fee your planner got a few years back. Theoretically, the MER -- the cost to you -- could fall by 70 basis points, but it doesn't, because when your investment is reclassified as no-load the planner's take becomes the going rate for no-load fund: 1 per cent. He picks up another 50 points and the fund company gets another 20.
The fund company could lower fees but it's clear that the planner can too, and he's the one getting more. So if mutual fund companies are feeling the heat and want to lower MERs, why do they allow this? Because they don't have a choice. You cross the financial planning industry at your peril, because they control the market -- they speak for you.
As long as investors don't pay much attention, planners control the game.
One assumes that most planners strike a balance between their interests and their clients but all of them are hurting these days. Their income has dropped along with asset values. They're in no mood to have their fees cut, so don't count on MERs coming down soon.