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DSC on death row –should we keep it alive?

BACKGROUND & HISTORY

Although mutual funds have been around in Canada for several decades, older investors may recall how mutual funds were sold in the early 1980s. There were no deferred sales charge (DSC) funds, low load funds or the various other permutations found today.

If you wanted to buy a mutual fund, you had to pay a commission called a front-end load. The front-end load could be as high as a 9%. The investor would receive a written confirmation detailing what the commission was (in dollars) what the price of the fund was, the name of the fund, purchase date, etc. Not much has changed today and if you choose to buy a mutual fund with front-end commission of 0%, you still receive the same confirmation details by mail shortly after the purchase date.

After the mid-1980s, the fund industry introduced a new way of buying mutual funds that neatly managed to side-step the lofty front-end commissions of the time. The deferred sales charge (DSC) was born. In this unique arrangement, an investor would pay 0% commission to buy a fund and 0% to sell a fund provided that he agrees to one condition: the investor promises not sell his fund within the first seven years of ownership. This is not to say that selling a fund is impossible but early redemption penalties could be severe (up to 6%) if you sold the fund soon after buying it. But if you kept it for the full seven years, you could sell all or part of your fund at no cost plus don’t forget, you didn’t pay any commissions when you bought it. At the same time, the fund companies introduced the concept of trailing commissions aka “trailers”. Trailing commissions are fixed annual compensation to the adviser for managing and servicing the account which provides the adviser annual compensation between 0.5% and 1% depending on the type of fund. Soon, the DSC way of purchasing a mutual fund became very popular.

The press thought this was wonderful – a win-win situation. The adviser gets paid, the investor escapes all commissions and the annual remuneration to the adviser (the trailer) would effectively kill the potential threat of “churning”. Trailing commissions changed the perception of mutual funds forever as advisors no longer had to make a trade in order to make a commission. From now on, mutual funds would not be traded as frequently as stocks.

By the late 1980s, Canada’s banks bought out most of the big stockbrokerage companies and the banks started creating no-load mutual funds of their own. No-load does not mean free as there is still a profit margin built into these products and there is an exchange of compensation from the fund management company to the retail bank side. However, from strictly the viewpoint of the bank customer – bank mutual funds are “free” and they were now in direct compensation with the independent, commission based adviser.

In a free market environment, competition is good and “free” is one of the most powerful marketing motivators of all. In the early 1990s the competitive marketplace became even more competitive as other no-load funds entered the fray. For instance, during that decade, one no-load firm, Altamira, became a juggernaut of the no-load world. Altamira ultimately, flamed out, crashed and burned during the “tech wreck” as legions of DIY (do-it-yourself) investors piled into their tech funds and then pulled it all out as the tech sector crashed. Altamira went from riches to rags literally, overnight.

In response to an increasingly competitive environment, by the 21st century,  advisors had to voluntarily cut their own commissions and front-end loads went from the high single digits to zero.

CONFLICT OF INTEREST

Some industry observers and regulators are targeting the DSC mutual fund indicating that the DSC has an inherent conflict of interest and should be banned.

Should DSC be banned? And does DSC represent a conflict of interest?

Back in the 1980’s and 1990’s we can make a pretty good argument that DSC was definitely not a conflict of interest. It eliminated churning (which is certainly a conflict of interest) and it saved clients from paying high commissions.

That was then but what about now? With front-end commissions at zero who would want to buy a DSC fund that could have a possible exit fee? As a result, DSC funds have greatly declined in popularity and for new mutual fund purchases, front-end mutual funds at 0% commission (set by the advisor) is by far, the most commonplace option to purchase a mutual fund today.

From a client viewpoint, the MER and performance of a DSC fund is the same as a FE fund ( at 0% commission) although one could argue that costs to set up the DSC limited partnership and legal structures to fund the up-front commission to advisers costs some additional incremental amount.

BEST INTEREST

The DSC practise of paying an advisor in advance seems to be the primary sticking point. One has to ask who it benefits. The answer is obvious -it benefits the advisor. A dollar received today is worth more than a dollar received later. Could DSC funds be seen as self-serving and not in the best interest of the client?

If there were no early redemption penalties, I might call it even but because there are, it is clear that giving client FE=0% commission is a better deal than DSC so if advisors claim they always work in the best interest of their client, one has to take a cold, hard look in the mirror.

It may be a moot discussion if regulators ban all commissions. If so, there would be no front-end loads, no DSC or low-load funds. Trailing commissions would be banned and replaced with fees. This would be unfortunate as the FE=0% commission model gets axed at the same time.

Although I disagree with the regulatory view that anything embedded is conflicted and must be banned, moving to a fee-based account presents its own set of conflicts of interest.

But that is another discussion.

In my view, DSC is very quickly dying a death of neglect. DSC once had its day - but that time is long gone.

Who will deliver the final coup de grace?

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The opinions expressed are those of the author and not necessarily those of Assante Financial Management Ltd.

Commissions, trailing commissions, management fees and expenses, may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the Fund Facts and consult your Assante Advisor before investing. This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please make sure to see a professional advisor for individual financial advice based on your personal circumstances.