A short history of mutual fund fees and commissions

I have been reading a lot of articles regarding financial advisor remuneration regarding the purchase of mutual funds in Canada.

I am amazed that so many senior business editors, heads of various trade groups and investor advocates have managed to make so many errors in their attempts to describe what the fees and commission structures are, how they work and how proposed new regulations might affect investors.

Here is some essential background.

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 front-end load commission by its very nature is open, transparent and disclosed. 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 an open, transparent and disclosed commission, you still receive the same confirmation details by mail shortly after the purchase date. In any case, no one has ever argued that front-end loads/commissions are not open, transparent or disclosed.

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 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 escaped the big front-end commission when you bought it. Soon, the DSC way of purchasing a mutual fund became very popular. At the same time, the fund companies introduced the concept of trailer fees. Trailer fees are a 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. 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”. Trailers changed the perception of mutual funds forever as advisers 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 definitely an exchange of compensation from the fund management company to the retail bank side. However, from strictly the view point 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 market 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 and 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. [1]

In response to an increasingly competitive environment, advisers had to cut commissions and front-end loads went from the high single digits to zero. With 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 purchases, front-end mutual funds at 0% commission (set by the adviser) is commonplace today. Therefore, those advisers living off 0% commissions and the annual trailer (0.5% to 1.0%) are being assaulted by the “make them bleed” press and also by investor advocates that believe (from the press, I gather) that any commission at all (even low ones) is truly evil incarnate.

Certainly we have a wide disparity of views out there.

Therefore, it with some bemusement that I see the media keeps referring to current adviser compensation as excessive and bloated. The DSC fund that was lauded by the press in the 1980s is now vilified by the same press in 2013.

The press indeed does have the regulator’s ear and the Canadian Securities Administration has decided that commissions in general might be, perhaps, possibly, could be, a problem. After extensive study of the subject, I am still trying to find out what problem they are referring to.

Commissions have declined precipitously, churning has all been eliminated, and mutual funds are the cheapest they have ever been. There is far more regulation now and compliance is at the tightest levels ever. So, exactly what is or where is the problem?

Does this mean the press, regulators and investor advocates are yearning for the good old days of the 1980s and 9% commissions – commissions that indeed were open, transparent and disclosed so long ago?

[1] National Bank bought the remnants of Altamira, successfully turned the company around and incorporated the Altamira name into National Bank’s own mutual funds.

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