Mutual fund fees and the future of investment advice

For more than 30 years, when you’ve bought a mutual fund in Canada with a deferred sales charge (or DSC), you’ve paid no upfront fee. The catch is that if you sold the fund before a specified period of five to seven years, you’ll pay a hefty penalty. DSCs usually start at 6% if redeemed in the first year and fall by 1% every year over the remaining schedule until they reach zero. The aim? To keep you invested in the mutual fund for several years because selling those funds early can cost you several hundreds—or even several thousands—of dollars in penalties.

Every year, DSC mutual funds fall in popularity. But, unlike in several other countries, until recently there was no outright ban on their use in Canada or, more broadly, no ban on embedded commissions for financial advisors. That is, until late December 2019, when securities regulators in every province and territory—with the prominent exception of Ontario—decided to ban upfront sales commissions on funds sold with the DSC option. The Canadian Securities Administrators (CSA), an association of regulators representing each of the provinces and territories, said it will also ban mutual fund companies from paying trailing commissions to discount brokers or any dealer that does not provide advice to clients. (Ontario is participating in this ban, although it has opted out of the DSC ban.) A transition period of two years will be allowed to put both bans in place.

Critics have long argued that embedded commissions skew advice and cause bias, and the CSA has finally agreed with them— although opt-out Ontario still accounts for 40% of all mutual fund sales, according to consumer advocate Ken Kivenko. The fund industry and salespeople who benefit from DSC continue to argue that redemption fees help small investors by bringing them financial advice they wouldn’t be able to get with small investment portfolios. So who’s right?

Based on our informal poll of prominent industry watchers, it’s the CSA.

Author and fee-based advisor John De Goey—a vocal critic of embedded compensation and deferred sales charges—says he’s disappointed by Ontario’s failure to join the ban. “I’m embarrassed to be an Ontarian right now. This is a province where the regulator [the Ontario Securities Commission, or OSC] is possibly the most progressive, but where the government [led by Doug Ford] is almost certainly the most regressive,” De Goey told me. He is a portfolio manager with Toronto-based Wellington-Altus Private Wealth Inc.

On the manufacturer side, Vanguard Canada executives support the CSA’s move. It is “encouraged that the Canadian market, like many other regions around the world, is moving towards aligning the sale and distribution of investment products with the best interests of all Canadian investors,” says Kathy Bock, managing director and head of Vanguard Canada. “Understanding the investment fees you pay and the services you receive is a fundamental part of achieving investment success, and we hope to see continued progress on that front.”

Whether Ontario eventually joins the ban or not, consumers have increasingly been voting with their wallets against DSCs, although the trend may be more a reflection of more no-load funds being sold through the retail bank network. Just 20 years ago, DSC funds accounted for 75% of mutual fund flows—meaning the value of all mutual funds bought or sold in a given year. By the mid-2000s, this fell to 60% and slipped to under 20% a few years ago. As of now, “we can confirm that today mutual fund assets in back-end purchase options (DSC and low-load) stood at 10.9% of total mutual fund industry assets,” says Pira Kumarasamy, spokesperson for the Investment Funds Institute of Canada (IFIC), citing market intelligence firm Strategic Insight. “This has been steadily declining over the years.”

During the heyday of mutual funds in the 1990s, new fund salespeople were told there is much upfront administrative, advising and sales work to do when selling mutual funds to clients, so upfront commissions compensated them for that. But the industry gradually moved from front-loaded sales charges of 9% (upon purchase of mutual funds) to almost none, and compensation shifted to small (0.5 or 1%) annual trailer commissions, which are embedded fees that compensate advisors directly for mutual fund sales and motivate them to continue to provide advice for as long as the clients hold those funds.

The DSC was created to preserve generous (5%) upfront commissions for the advisor, a cost that the industry recoups by levying the aforementioned redemption fees. However, those commissions tend to be higher than for other types of mutual funds sold with different “class” structures that provide more flexibility for investors.

Can investors with small portfolios benefit from DSC mutual funds?

Warren Baldwin, a retired fee-based advisor, never used DSC mutual funds, but feels there still could be value in DSCs for smaller clients. On $10,000, a DSC advisor might receive an upfront commission (from the fund company) of $500. That may be a good deal if it delivers appropriate advice and guidance over several years, which was the rationale for DSCs: to keep investors fully invested through volatile markets. But if the $500 turns out to be just a quick transaction because the investor exits the fund at the first sign of trouble, it’s different. “That’s always been my beef with DSCs,” Baldwin says. Fee-for-service advisors “charge a fee upfront that you see, and here are the services we provide for that fee. It’s simple to see the cost/benefit: you be the judge.… The problem is with the mutual funds where everything is embedded and there’s often no clear cost communication to the person paying the bill.”

Clearly, regulatory momentum is increasingly in favour of greater disclosure of all third-party compensation (a third party is an institution that sells or distributes mutual funds to investors for fund management companies) through more transparent “fee-based” advice models such as is used in F-class funds (F stands for fee). Ideally, both sides should benefit and the shift from embedded compensation to fee-based advice should be a positive.

But in the absence of an outright ban on DSCs, the shift to fees and F-class is slow (in F-class shares, advisory fees are charged separately by advisors). For investors and the industry, it’s very hard to make apples-to-apples comparisons of the major embedded compensation families (DSC and front load funds, traditionally known as A-class funds), and the major independent families that do not use DSC and/or embedded compensation (non- or low-embedded-commission funds).

There are F-class versions of the big embedded-compensation families (which do not include trailers) and traditional A-class series funds. Many of these are actively managed, although several (notably the bank families) also provide index mutual funds; either way, these are just a tiny fraction of the embedded A-class/DSC funds. MERs (that is, fees) tend to be about 1% higher in the embedded compensation camp than the direct-to-investor group of investment managers, and the difference can be greater still for the direct-channel firms that further reduce fees based on rising client asset levels or amount of time held.

Direct comparisons are harder still when you keep in mind that the non-embedded independent firms include advice in their lower MERs.

A-class vs. F-class mutual funds

An American study on Canadian advisors —“The Misguided Beliefs of Financial Advisors”—found while most don’t have bad intentions, some harbour misguided beliefs. The problem isn’t conflicts of interest surrounding embedded compensation, but wrong beliefs or practices like return-chasing, which is defined as a psychological mistake where an investor puts more money into expensive actively managed mutual funds with high past returns funds. It prompted De Goey to publish his second book: STANDUP to the Financial Services Industry (see my MoneySense review here).

De Goey long ago shifted clients from the embedded-commission model to a more transparent, fee-based one. He says “there ought to be no future” for DSCs, but “alas, given the Ford government [in Ontario], a discredited product line continues to exist when it should have been put to bed. It will be used only by low-end advisors and likely only on gullible, unsophisticated clients.”

De Goey says, “no person would consent to be given bad advice.… Similarly, no one would consent to being sold an inferior product if they knew better products (or better variations of identical products) existed.” He says not all funds that pay trailers use DSCs; 90% of embedded A-class funds are sold with front loads of 0%, plus a 1% trailer for advisors, while 9% are A-class funds that pay both the 5% upfront commission and impose a DSC, plus pay advisors a 0.5% annual trailer. “It’s the same fund and the same MER.” F-class is only 1% of the market by assets; while those funds back out the 1% trailer, the advisor tacks on a mutually agreed-upon additional fee. And if the advisor is in demand, that fee could be and often is even higher than 1%.

Salman Ahmed, a portfolio manager with Steadyhand Investment Funds, notes that while F-class improves on the problems of conflicts of interest and transparency, it doesn’t address the problem of high costs or return-chasing. F-class fees are usually equal to the fees of A-class minus the trailer—but keep in mind that the F-class investor still has to pay the advisor now that there is no trailer in the fund, so the overall cost difference is minimal. In fact, Ahmed adds, many fee-based accounts often charge clients more than 1% for advice on top of fees for F-class funds.

Few sources outside the IFIC defend DSCs, so there should not be much mourning their passing outside Ontario. Even respected fund analyst Dan Hallett, a principal at Oakville-based Highview Financial Group, wrote in Investment Executive last March that “DSCs should be banned.” In December, he told one newspaper that Ontario was being arrogant and applauded the other CSA members for “moving forward with the right decision.”

Ken Kivenko, president and CEO of Toronto-based Kenmar Associates, says 85-year-olds are often sold DSC mutual funds that lock them in for seven years. “Often these are sick people and the advisors who sold them likely knew they had no emergency fund.” Encouragingly, the same day as the CSA’s ban outside Ontario was announced, the Ontario Securities Commission said it was considering several “alternative approaches” to DSCs, including banning their sale to seniors, prohibiting borrowing to buy DSC funds, and providing “hardship exceptions” from redemption penalties.

Michael J. Wiener, the blogger behind Michael James on Money, “can’t think of any context where DSC is defensible.” Mark Seed, who runs the blog, encourages investors still in DSC funds to learn the penalties to transition out of them. If the schedule has several years to run, “consider ripping off the Band-Aid now and divesting of them sooner rather than later…and good riddance.”

Cut the Crap Investing blogger and former advisor Dale Roberts says DSCs no longer serve a purpose: “It only serves advisors and mutual fund managers. Advisors don’t need DSCs to run their operations profitably. They’re doing more than fine with the typical wealth-destroying 1% annual trailing commissions that are usually attached to equity funds.”

The mutual fund market “has evolved”

While regulators in Australia and the United Kingdom banned trailer commissions a decade ago (as has New Zealand) hopes that Canada might follow suit were initially dashed last year. In September 2018, Ontario first rejected the CSA’s proposal of June 2018 to ban DSC-sold mutual funds altogether. The CSA has it right, while “Ontario got it wrong,” says fee-for-service financial planner Robb Engen, the blogger behind Boomer & Echo.

But even if Ontario fails to follow suit any time soon, the industry itself may ultimately do the job. As Engen notes, “the writing was on the wall that DSC funds are on the way out when Investors Group decided to discontinue selling DSC funds three years ago. At the time their president said ‘DSC was created to provide discipline to long term investing but the marketplace has evolved’.”

What you need to know about fee-based advice

While fee-based advice is more consistent with investors’ well-being, it’s not always squeaky clean. Twelve firms were sanctioned for double billing on fee-based accounts over the last three years: some put embedded-compensation mutual funds into fee-based accounts, collecting both trailers plus the asset-based advice fee. “Over $350 million had to be given back.… Even if you buy GICs or money market funds they stick them in your fee account, charging 1% [on the whole account]…won’t change much as long as there is no fiduciary or best interest standard. Almost no payment system protects you from egregious conduct,” says Kivenko.

In its submission on embedded fees released before the December 2019 ban announcement, IFIC said the foreign experience found any reduction in advice or rise in costs negatively impacted investor outcomes: “Investors with no further access to advice will have lower levels of assets in retirement than investors who have had the long-term and consistent benefit of an advice relationship throughout their investing lives.”

And the Mutual Fund Dealers Association of Canada (MFDA) said a “ban of embedded compensation would eliminate the DSC commission and may result in advisors having to charge clients an upfront fee to cover the cost of their services.”

However, blogger Dale Roberts, formerly with Tangerine, doesn’t agree that eliminating DSCs would lead to an “advice gap” and says the industry should ban DSCs and trailers regardless. For those with little wealth, “there is advice abuse.… Canadians pay high fees and get no advice or terrible advice.”

Three years ago, Dan Hallett, the vice-president and principal of HighView Financial Group, argued here that the industry already had a “stealth” advice gap. Not surprisingly, larger clients get more time and attention than small ones, who are lucky to get one face-to-face meeting a year.

Still, many investors value active management and the advice that comes with mutual funds. They can get both (and even passive management if preferred) with fee-based accounts holding F-class funds with no hidden trailers; advisor and client agree on a fully disclosed annual fee based on a percentage of assets, often 0.5% to 1.5%. They can also own low-cost passively managed ETFs, or if they don’t need advice and don’t wish to pay for it, self-directed investors can buy either mutual funds or ETFs directly through discount brokers.

Investors seem to agree. In fact, F-class fund sales almost tripled in the last four years, IFIC says. “F-Series mutual funds accounted for 17% of all mutual fund assets at the end of 2018 and total $211 billion. In 2014, F-Series mutual funds accounted for only 6% of all mutual fund assets and totalled $61 billion.”

While rare compared to the household-name embedded compensation/DSC shops, a handful of independent actively managed fund companies are still available either directly or through funds not sold with DSC or trailers, some with F-class shares.

Jonathan Chevreau is founder of the Financial Independence Hub, author of Findependence Day and co-author of Victory Lap Retirement. He can be reached at




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