The real problem with fund fees

By Dean DiSpalatro | October 3, 2014 | Last updated on October 3, 2014
3 min read

My first experience with an advisor wasn’t good. In early 2007, I was an academic preoccupied with geopolitics, with little knowledge of the markets and even less of the vehicles people like me—the most retail of retail clients—would use to access them.

I walked into my branch and told the teller I wanted to invest $1,000. He herded me to a waiting area and, eventually, I got an appointment with the resident advisor.

She did a terrible job.

We discussed risk for a few minutes. I explained I’m normally conservative with my finances, but on a whim I felt bold, excited by the prospect of making money with no effort. I put it all in a U.S. equity fund.

When it tanked, I panicked and ran for the exit.

I didn’t know the fund’s fee structure, but that soon changed. It had a DSC schedule, and I got clobbered. I’m sure the hefty stack of documents I received at the outset explained fees in excruciating detail. But who reads fine print?

While I’m not blameless, that advisor gets an F (even by pre-CRM2 standards). But if you think I want a ban on embedded commissions and DSCs, you’re mistaken.

Read: Is advisor fee deductibility really beneficial?

In a free society, regulators have no business nudging consumers this way or that. Their job is to enable people to make informed choices.

Closet indexers abound

A May 2014 study found that 56% of Canadian domestic funds are closet indexers.

For American domestic funds, only 14% are closet indexers.

Source: Cremers, Ferreira, Matos and Starks, “The Mutual Fund Industry Worldwide.”

Take someone who has $70,000 to invest, and has neither the time nor inclination to figure out which robo-portfolio suits him. Fee-based is out of reach, so commission structures are what give him access to advice.

And with CRM2, he’ll know how much he’s paying, how his advisor’s paid, what services are provided, and what his costs will be if he bails. If commissions—which usually cover ongoing services beyond asset allocation—are as offensive to him as some industry observers opine they should be, let that be his motivation to learn how to DIY.

Regulators are due to revisit the issue of embedded commissions early next year, but their efforts are better directed elsewhere. More important than how advisors are paid is what clients are paying for. Recent research suggests it may not be what they think.

Read: Top tips from portfolio managers in 2014

By now, you’ve become familiar with active share. The metric shows how far a fund manager’s holdings deviate from the benchmark. The researchers who devised it found most managers who claim to be active are actually closet indexers, which means they charge active-level fees for what is little more than an index product.

Regulators shouldn’t dictate who charges what for which product. But, it’s completely appropriate for them to require that manufacturers add active share scores to Fund Facts. Devising a comparable measure for active bond funds should be a longer-term goal.

Active share won’t tell clients how a fund will perform, but it will warn them about managers who charge more than they’re worth.

Maybe a little sunlight will spur more managers to live up to their billing.

Read: How to answer common fee questions

Read more: Can a robot replace you? >

Jessica Bruno is a Toronto-based financial writer.

Dean DiSpalatro