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The Second Opinion #4: Understanding Fees
Toronto - The Ontario Securities Commission is reminding investors that there are a number of fees that can be associated with mutual funds. Despite strict disclosure requirements, however, some investors still think of mutual funds as "no-fee" investments. In fact, mutual fund fees can significantly impact your investment returns. Consider the fees attached to the purchase of mutual fund units when making your investment decisions.
Fees paid when you buy mutual fund units
Sales fees can be either “front load” or “back-end” load. Front load fees are charged against your initial investment as a percentage, and are paid directly by you to the dealer when you purchase units in the fund. You may be able to negotiate front load fees with your dealer.
Back-end load fees are paid by the fund management company to your mutual fund salesperson – you do not pay this fee. You do, however, pay a ‘redemption fee’ if you redeem your units in the fund before a certain time period, typically 7 years. Redemption fees decline each year that you hold the investment.
No-load funds are funds without front load or back-end load fees. Keep in mind, however, that purchases of most funds, including no-load funds, are typically subject to Trailer Fees discussed below.
Special fees may be applied to your fund account, or billed directly, and include:
- Short-term trading fees, if you make withdrawals within 90 days of the initial investment .
- Initial account set-up fees
- Annual fees for RRSPs, RIFs or RESPs.
- Transfer fees for switching between funds
Fees paid by the fund (and indirectly by investors)
Management fees, operating expenses and taxes are collectively expressed as a percentage of the fund's total value. This percentage value is called the Management Expense Ratio (MER). MER values depend on the costs of managing each fund, and may include marketing, sales, administration, legal, accounting, reporting and portfolio management costs. These costs are charged directly to the fund, and reduce the value of your investment. While a fund’s MER may seem quite small, a small fee increase of just one percentage point can significantly reduce the rate of return of your investment over the long term.
Trailer fees are meant to compensate mutual fund salespeople for ongoing services they provide to their clients. These fees are paid by the fund management company (out of the management fee) to your mutual fund salesperson on an annual basis as long as you remain invested in the fund. Trailer fees are typically 1% for funds sold on a front-load basis and 0.5% for funds sold on a back-end load basis. Some trailer fees go up the longer you stay invested in the fund.
Since trailer fees are paid out of the management fee, they are included in a fund’s MER. Also note that the MER includes the up-front costs to the fund management company of financing back-end load fees.
Brokerage charges, which are the fund’s cost of buying and selling securities in its investment portfolio, are paid by the fund but are not included in the MER. These charges can impact the value of your investment. Information on the amount of brokerage charges specific to your fund will now be provided through the Trading Expense Ratio which must be included in your fund’s Management Report on Fund Performance prepared on a semi-annual basis. The Trading Expense Ratio represents the percentage of the fund’s assets used to pay commissions and other portfolio transactions costs on the fund’s investment portfolio.
Read the prospectus and financial statements before investing
Before investing in a mutual fund read the prospectus, which includes a description of all fees associated with the fund, as well as the fund’s financial statements. Compare the fund’s holdings, MER, and investment objectives with other similar funds to make sure you are getting the best return on your investment. If you have further questions, consult with your financial advisor to ensure that you are clear about all fees related to your investment.
There are many mutual funds with different fees and objectives so be sure to make use of available resources to make an informed investment decision. The Investor Education Fund website www.investorED.ca has a Mutual Fund Fee Impact Calculator that can help you compare the fees associated with different mutual fund investments. Contact the Ontario Securities Commission toll free at 1-877-785-1555 for further information.
You may or may not be paying too much in fees and commissions, but if you don’t know how much you are paying, you have no way to make a fair judgment
During the bull market between 1982 and 1999, many investors considered a 12% rate of return to be the minimum acceptable. They were paying high management fees on their mutual funds, but most did not object to the fees because they were satisfied with the net return they were receiving.
Today, things are different. Many industry experts predict that during the next decade, investors should not expect more than single-digit returns on equity investments. Fees, therefore, become a more important consideration. When the gross return on your investment was 12% and you paid a 3% management fee, you were in effect paying 25% of the gross return in fees. That was bad enough. But if the gross return is only 6% and you are still paying a 3% management fee, you are now paying 50% of your gross returns in management fees. Obviously, paying half your income in fees slows down the growth of your retirement fund.
One difficulty in determining actual fees is the number of types of fees, some of which are hidden or buried in the fine print. For most investors, it is difficult to know how much you are actually paying. This is especially true with hedge funds, which may have hidden fees, particularly if there are capital guarantees attached. In many cases, the only way to determine the amount you are paying in fees is to ask your financial advisor for a full report.
The commissions you pay on stock trades are obvious. When you buy or sell a stock, the commission charged is shown on your transaction slip. With mutual funds, segregated funds, and hedge funds, however, there may be two fees. The first is the transaction fee, which may be paid either as a font-end fee, which you would see, or as a deferred sales charge, which you would not see.
Buried in the fine print is the second cost, which is the on-going management fee. The fee is included in the management expense ratio (MER). It includes the management fee and other costs, such as legal and audit, advertising and printing, and costs related to guarantees and to operating the fund. The MER does not include trading costs incurred by the mutual fund. Published rates of return for mutual funds are always the net return after management fees have been deducted, and this is usually, but not always, the case with hedge funds.
You may be paying reasonable fees. If so, you should be grateful to your advisor. But you may be paying excessive fees. The solution: find out how much, both in percentage terms and actual dollars, you are paying for your investment advice.
Don’t ask your advisor for a detailed account of fees that you’ve paid for the last five years. The advisor will know what you are paying currently but it is too much to request an analysis of how much you paid in previous years.
Your advisor can tell you, for example, how much the “spread” or commission is on your bond purchases. The fee on a bond purchase is hidden. You purchased the bond out of the inventory of the brokerage firm. In effect, the firm buys wholesale and you buy the bond as a retail customer. A commission charge will increase the cost of the bond, and you have a right to know the cost of the charge.
Fees are necessary and investors would have very limited choices without the help of professionals who make up the industry. It works both ways: professionals must be able to charge fees and you must be willing to pay reasonable fees. What is an appropriate overall level? It will vary depending on the size of the account and the level of service, but the normal range is between 2% and 2.5%.
Bottom Line: You can’t make any judgment about fees unless you know how much you are paying. Fees should be clearly spelled out, ideally in the investment policy statement.
What you can do now: Ask your financial advisor for a complete picture of what you are paying in management fees and commissions.
Ken Hawkins
“Trailer: A furnished vehicle drawn by a truck or automobile and used when parked as a dwelling.”
American Heritage Dictionary
Last Sunday morning, my 13 year old grand daughter was visiting and she was sitting with me on the deck enjoying the sun and the view. As a grandfather I like to make sure that my wisdom is passed on to those less experienced and knowledgeable. An article in the paper about mutual fund fees caught my attention and I felt it was my duty to help pass on some financial wisdom. So I asked my grand daughter a question;
“Jordan, what are trailer fees?”
“Granddad, don’t be silly. You know what they are!” she replied.
“But do you?” I responded.
Very pleased with herself she answered, “Of course I do. Trailer fees are the fees that Bubbles, Ricky and Julian (The Trailer Park Boys) pay every month to the Sunnyvale Trailer Park.”
Laughing out loud, I said, “That is a very good answer and just as clear and understandable as any I have seen. Not only did you inherit my good looks and brains but obviously, my sense of humor as well. You were close but they refer to mutual funds not trailer parks”
“I knew that but I just wanted to pull your leg. However, I really do not know exactly what they are.”
“You are not the only one, as most people do not understand them or even realize that they pay them. According to The Investment Funds Institute of Canada, Trailer fees are ongoing commissions paid by the fund company to advisors and dealers for ongoing service and advice. Each year the dealer gets an amount that equals a certain percentage of your account’s value. This can vary depending on the purchase option and is often about 1% on front-load accounts and ½% on DSC accounts with your advisor receiving a portion of those payments. No-load companies may also pay trailers to dealers. Dealers disburse the fees to their advisors, financial planners, sales representatives, and bank employees. You do not pay trailer fees directly. They are paid by the mutual fund company -- in most cases from its management fee. As with commissions, funds that carry low trailers or none at all may or may not have lower management expense ratios.”
“Granddad, I still do not know what they mean. Can you explain them to me?”
“Ok. Imagine that mutual fund companies are really owners of trailer parks. Let’s assume Bubbles wants to move to a new trailer park. He has his eyes on a nice double wide trailer in the “Safe Harbor Trailer Park” owned by the Thompson Trailer Park Corporation. He can not just go to the trailer park and buy that double wide beauty. He has to go to a Trailer Park Advisor and she will purchase it for him. He will pay a commission to the Advisor for helping him to purchase the trailer”
“Is that what they mean by trailer fees?”
“No, but we are getting closer. Once Bubbles moves into his new trailer, he has to pay management fees to the Thompson Trailer Park Corporation for managing the Safe Harbor Trailer Park. It will help pay for the on-site manager who manages the property as well as regular maintenance and any improvements they make to the Safe Harbor Trailer Park”
“Is that what they mean by trailer fees?”
“No, but we are almost there. Part of the management fee will go the Trailer Park Advisor who sold him that double wide trailer for as long as he owns it. It is supposed to pay for the advice and service that Bubbles will get from the Advisor. That fee is the trailer fee.”
“Granddad, if Bubbles just moved in, why would he need any more advice from the Advisor about the Safe Harbor Trailer Park? If he doesn’t need or want the advice, then does he have to still pay for it?”
“He still has to pay the trailer fee even if he does not need or want the advice, for as long as he lives there.”
“When he buys a trailer he pays a commission to the advisor. “
“Yes”
“If he does not sell it, he pays another commission in the form of a trailer fee to the same advisor.”
“That’s right”
“Then Bubbles pays a commission for buying the trailer then he pays more commissions for not selling it.”
“Now you understand trailer fees.”
“Granddad, the Mutual Fund Sales business sounds like a pretty good business”
“You are right. Where else can you make money by selling a customer a product and then the same customer will pay you more money for keeping it?”
“Granddad, why do they call those commissions, trailer fees?”
“Another day”