Getting Screwed by the Mutual Fund Industry
Investors should offer a rare Thank You to the Canadian Securities Administrators.
From the website: “The 10 provinces and 3 territories in Canada are responsible for securities regulations. Securities regulators from each province and territory have teamed up to form the Canadian Securities Administrators, or CSA for short. The CSA is primarily responsible for developing a harmonized approach to securities regulation across the country.”
The CSA’s reach extends across stocks, bonds and mutual funds. It’s that last category where the CSA has recently earned kudos from investors.
The largest problem with the mutual fund industry is that it’s built on “gathering assets”. If the fund company charges a 2% management fee, then having more assets under management means more gross dollars flow to the manager. Then once a manager has cash in hand from investors, it will do whatever it legally can to prevent the investor from repatriating the cash. After all, less investment on hand means smaller fees.
Forests of research have shown that non-specialty mutual funds regress to the market mean over time. No one can outperform the market forever. In the long run, the fund manager is relatively meaningless to the fund’s gross return. Smaller specialty funds (like those aimed at gold, or Brazil, or hitech) bend in the breezes blown by their target markets, but within their own universes, they too regress.
So how does a fund company keep its investors from moving to another mutual fund? They call it “trailer fees”. I call it a bribe.
Get our daily investorintel update
Bribe: Something, such as money or a favour, offered or given to a person in a position of trust to influence that person’s views or conduct.
Sounds like trailer fees to me.
Trailer fees are fees paid by a fund company to an investment advisor on an annual basis, for every client that advisor has invested into one of the fund company’s funds. It takes effort to find out what fund companies are paying for trailer fees; they don’t want the average investor to know. Reading through the annual reports and audited financials are not easy exercises. My research shows the trailers range from about .4% to .8%.
On a hundred thousand dollar investment into a mutual fund, and after the initial commissions have already been paid, that means that .8% is taken out of the fund off the top, regardless of performance, and paid to the investor’s advisor. That’s on top of the annual management fees and all the other items that make up the Management Expense Ratio. That means there are fewer dollars to actually invest, which in turn means that the remaining dollars that are invested must generate a gross above average return just to generate a net average return, so the investment manager must take greater risks to get to that above average return.
The industry justifies trailer fees by saying that the advisor provides annual advice to the client investor, and should be compensated for the time spent. In other words, if the advisor convinces the client not to move to a better performing fund, the advisor will get paid another fee in addition to the original commission paid. The advisor, in a position of trust, is paid money to influence that advisor’s views or conduct.
And this is where the average mutual fund investor gets treated like Ned Beatty in Deliverance.
The CSA commissioned a research study from Dr. D. Cummings, Professor and Ontario Research Chair at the Schulich School of Business at York University. His comprehensive research was extracted from a data pool running from 2003 to 2014, looking at $746 billion dollars under management, pulled from 43 fund families. It was released in October, 2015. Given its dramatic conclusions it has received shockingly little coverage from the mainstream media.
Dr. Cummings’ empiric conclusion was that a 1% increase in trailer fees is connected to a 1.43% drop in returns. In other words, the larger the trailer fees paid to the investment advisor, the worse the fund performs.
It gets even more abusive. The research also showed that when the trailer fee was reduced (and the investment advisor was less motivated by annual recurring commission), the fund’s return increased.
So, the inescapable conclusion is where mutual funds are involved, the majority of investment advisors steer investors to funds where the advisors get paid more, more reliably, longer, even if the investor loses in the long run.
And, as an aside, the study also found that funds sold by independent dealers outperformed funds sold by affiliated dealers. No surprise there either.
Look at the full research paper here.
Is anyone surprised by this?
This isn’t a slam at the advisors. They do what they do on a daily basis, to earn a living, well within the rules of the industry. The problem is the rules of the industry.
In the early 2000’s I consulted to a large well-known mutual fund manager. It wanted a report validating trailer fees and its income structure. My report advised the manager to be different – to repute trailer fees and stand only on its performance. Think of the marketing potential of actually being better. The problem was, the manager didn’t know if it would actually be better going forward. The manager paid me, thanked me for my time, and never called me again. They were following the mutual fund industry’s rules.
This is typical of the industry. The mutual fund industry thrives on being average and encouraging a “buy and hold” approach, even though the math doesn’t support that position. This doesn’t even touch the skanky offshore hedge funds hiding within insurance wrappers. Management companies will advertise (heavily through RRSP season) about their integrity and judgment, but in the end, there’s very little difference between a burger from Wendy’s or from Harvey’s.
What does this mean? The obvious conclusion is not to buy a mutual fund from an affiliated dealer where that fund pays a trailer fee. The less obvious conclusion is to buy an ETF that follows that same market, at a much smaller long term cost to the investor.
The internet has disintermediated many agents. For example, discount real estate brokers use the internet to displace full service brokerage firms, and we can all get accurate local information on the price of a used car. The underlying service providers have had to adapt to changing times. The mutual fund industry must adapt before investors leave for more fair investments.
Mr. Clausi is an experienced investment banker, executive and director. A graduate of Osgoode Hall Law School called to Ontario's bar in 1990, Mr. Clausi ... <Read more about Peter Clausi>