Having spent many years in and around the mutual fund business, it always surprises me to see how little people seem to know about the actual costs of the funds they’re buying. They know it’s important, but seem to have a bit of trouble with the math.
Most look to the management expense ratio (MER), the percentage of assets that a fund siphons off for operating each year, to get a handle on their costs. But you really have to break things down further.
Management fees are the biggest component of a fund’s MER. These include the portfolio manager’s costs, sales commissions, marketing and advertising costs, and continuing service or trailer fees to advisors.
Watch For Embedded Compensation
It’s these latter costs, or rather the lack of them, that constitute the biggest difference between no-load, do-it-yourself funds and those sold through advisors. And the difference can be significant, so much so that Canada’s securities regulators recently suggested that trailers be eliminated altogether (as they have been in Great Britain) or at least capped at a lower level.
Here how trailers work: Each year the dealer or advisor gets paid an amount that equals a certain percentage of your account’s value – generally one per cent for equity funds and something closer to half that on bonds. The actual fees vary slightly among mutual funds companies, who sometimes adjust them to encourage sales, but the pattern is the same.
That means that, indirectly, you’re paying up to one per cent of the money you’ve invested in that fund every year to the person who sold it to you. If you have, say, $10,000 in assets, then you’re paying up to $100 a year; if you have $100,000, then you’re handing over as much as $1,000 a year.
Getting What You Pay For
You may well be getting your money’s worth in the process if you’re getting the advice you need. But the advisor gets the commission regardless of how the fund performs, how little he or she services the account or how unhappy you are.
The industry argues that trailers prevent churning – jumping from fund to fund to boost commissions – and promote a managed approach in which advisors look further down the road when building portfolios, particularly for smaller accounts.
Critics charge that they’re just one more way for fund salespeople to line their pockets without really having to highlight investors’ true costs. These types of incentives, they say, create constant undisclosed conflicts of interest because advisors will always go with the highest bidder.
Be Sure To Negotiate
While this certainly may be true for some advisors, you’re really only interested in the few people you turn to for counsel. That’s why you should quiz them on what you’re actually paying and how, and have them explain what you can expect to get for your money. Then use this information as a fulcrum upon which to balance your negotiations.
Ideally, you’re trying to create a partnership where all parties have all the facts and an equal stake in the results.
Since the value of really good advice can be significant, getting too hung up about trailer fees or simply going with the lowest-cost provider can prove to be short-sighted. But, in an era of increasing competition and disclosure, not taking a second look at what you’re actually paying is downright silly.