- Details
- Written by Glenn Szlagowski
- Category: Newsletters
- Hits: 6864
New mutual fund reporting - art or science?
In doing my own research on mutual fund rates of return and even gain/loss calculations, I quickly found it to be a complex subject, even for someone that has a mathematical background. I consulted with widely respected analyst; Dan Hallett1, Morningstar Canada editor Rudy Luukko2 and Andre Fok Kam3 about some of the big changes regarding investors’ statements and reporting that we will see in 2017.
Mr. Luukko had some reservations about book values on client statements and cautions readers not to use them for their taxable gain/loss calculations. Book values (sometimes referred to as book costs) sometimes do not reflect their proper adjusted cost base used for tax calculations. Dan Hallett also questions the usefulness of book values. He says: “[Book values] may or may not reflect ACB or net amount invested. But for most, it’s unlikely to be an accurate measure of either.”
Here is another scenario where a book value may not reflect a true gain/loss. Because book values increase with each reinvested distribution, for some fixed income mutual funds that reinvest large distributions on a regular basis, you could theoretically encounter a situation where the book value exceeds the market value. Mathematically, this would show as a loss when in fact, the mutual fund could have a gain.
Why is ACB (Adjusted Cost base) so important? Tax professionals would use ACB to determine capital gain/loss for tax purposes. What about book values? Mr. Luukko says the intent of using book values was to comply with new regulatory requirements (CRM2) as securities dealers are mandated to provide gain/loss information to investors.
Dan Hallett has written an excellent article (with examples) on the new but very different way of calculating a rate of return called dollar or money weighted rate of return. A link is provided at the end of this article. Investors will be seeing these different performance numbers in a brand new Investor Performance Report that will be mailed out in 2017. In his article, Mr. Hallett cautions readers to be careful with these reported performance numbers, noting that calendar date biases may result in numbers that may not be meaningful in certain circumstances or comparing rates of return with other advisors may be difficult.
Securities regulators have decided that money weighted/dollar weighted return is to be used from now on. This formula is also referred to as the IRR (Internal Rate of Return). The return of the mutual fund itself uses a different formula called a time weighted rate of return.
Although the regulators have decided that advisors and their firms must use money weighted rate of return calculations, Mr. Hallett says he would have preferred to see time weighted calculations as did the CFA Institute. “Time weighted would have made so many things much easier – e.g., comparisons with broadly based indices; custom benchmarking; calculation of other performance metrics like Sharpe, alpha, etc.”
While regulators allow the advisor firms to use any method for internal reporting purposes, the money weighted return method must appear on the new Investor Performance Report that investors will be receiving in the mail in 2017. Some Dealers will be giving their advisors the option of adding time-weighted returns to advisor generated rate of return reports so investors can see both money weighted and time weighted rates of returns.
However, investors should be aware of some of the disadvantages of using money weighted (IRR) rate of return calculations. For instance, the formula presumes all cash flows during the time frame measured, are reinvested at the same internal rate of return – an assumption that some believe is completely unrealistic. Although empirically, the IRR is only the number or numbers that makes the Net Present Value of the cash flows = 0 in the IRR equation. If there are multiple rates of return that satisfies the equation, then that’s just the math. Having said that, in speaking with a mathematician - a Ph.D. in Applied Mathematics, there could also be a correlation between cash flow size and the possibility of multiple returns as well. He cautioned about “black box” formulas that do not handle IRR calculations very well and had some cautions about the use of Excel for IRR calculations.
Much of the modern literature seems focused on “fixing the IRR problem” by approximating the IRR formula using other equations. Ironically, the newly mandated use of IRR replaces the previous preferred rate of return model called the Modified Dietz Method which doesn’t have the multiple rate of return problem.
In the paper5 from Yuri Shestopaloff, Ph.D. and Wolfgang Marty, Ph.D. (Properties of IRR Equation with Regard to Ambiguity of Calculating of Rate of Return and a Maximum Number of Solutions) the authors appear to prefer the Modified Dietz Method for the calculation of rates of return.
If there are a number of swings of money coming in and going out of a mutual fund account, calculating an IRR rate may result in two or more multiple rates of return4. Or even worse –none. Mathematically speaking, each of these multiple returns are 100% correct and the observer is sometimes left with the difficult task of choosing one over the other. Sometimes it may not be intuitive which one is the “more correct” answer.
[Editor’s note: Although mathematicians can appreciate the beauty of pure math and report there can be more than one correct answer for the same polynomial equation (Descartes Rule), telling investors they could have multiple rates of return for the same mutual fund –all of which are perfectly correct –will make for some engaging discussions.]
Dan Hallett says that many clients have money moving in or out of their accounts and Descartes Rule can be a real issue for them.
Although going forward, calculating money weighted (IRR) rates of return (despite the challenges) could be for the most part, useful, there is a red flag regarding the transfer of mutual funds from one dealer to another. Mr. Hallett is referring to a dealer change when an advisor moves from one dealer to another. This is a very common scenario. In this case, the client’s mutual funds are transferred intact [this is called an in-kind transfer] from the relinquishing dealer to the new dealer at the market price the day the units are received by the new dealer. For the purpose of calculating a money-weighted rate of return (IRR), the original purchase cost(s) of the mutual fund do not move to the new dealer so the transfer-in of securities is posted at market value. If it is counted as a very large new purchase it could skew the IRR and it is debatable whether the rate of return would be meaningful. This will likely affect the “since inception” rate of return if you opened your existing account with an in-kind securities transfer. If the time frame measured excludes the securities transfer, all the other rates of return (except the “since inception” return) i.e. 1 year, 3 yr, 5yr or 10 yr returns should be OK.
Difficulties may also arise if a mutual fund is consolidated or merged with another mutual fund resulting in a large in-kind “purchase”. Again, this has the potential to skew returns. Your advisor is best equipped to discuss or alert you about these special situations.
However, Dan Hallett emphasized if the in-kind transfer is “new money” - say from another firm or another adviser, then it can be used as a basis for rate of return calculations.
Andre Fok Kam on the other hand, has a different viewpoint with respect to in-kind transfers of securities. According to Mr. Kam, an in-kind securities transfer is treated the same way as a new cash purchase of a mutual fund and under the letter of the law, the percentage rate of return generated would be perfectly valid under the new CRM2 securities rules.
Notwithstanding the potential issue of multiple rates of returns, if you never have an in-kind transfer in your account and opened your account with a cash purchase rather than a securities transfer, then all of your returns –including since inception should be OK.
Although convention would hold that the best way to measure performance is to compare original costs with a market value – transaction histories are not transferred when a client changes advisors or advisors changes firms. As a result, original costs are left behind. Although attempts have been made in the past to use book values(which incorporates original costs) for rate of return calculations, book values are incremented up every time you re-invest a distribution (so you aren’t taxed twice) in a taxable account. As a result, some say that book values should not be used for performance rate of return calculations at all.
Confusing? It can be. When you receive your new Investor Performance Report, bring it in to your Financial Advisor so both of you can review and discuss it in more detail.
References:
1 Dan Hallett is Vice-President & Principal of Oakville, Ontario-based HighView Financial Group. Dan's views and opinions are regularly featured in the media and have appeared in several best-selling personal finance and investment books. He is a regular contributor to the Globe & Mail and many other business publications.
2 Rudy Luukko is editor, investment and personal finance, at Morningstar Canada. A former chair and founding member of the Canadian Investment Funds Standards Committee (CIFSC), he has also co-authored courses for the Canadian Securities Institute.
3André Fok Kam, CPA, CA, MBA is a consultant to the securities industry. He has advised regulators, fund managers, advisors and dealers.He has served on the Board of Directors of several fund managers, portfolio advisers and dealers and has served as Investment Director and CCO. He writes extensively for several trade publications.
4Descartes Rule: There is an indirect relationship between Descartes rule and the number of sign changes between positive and negative cash flows in or out of a portfolio ( money moving in and money moving out), then mathematically, there is a possibility of multiple rates of returns generated by the money weighted rate of return (IRR) formula. Search term: Descartes Rule of Signs.
5 Yuri Shestopaloff, Ph.D.,Wolfgang Marty, Ph.D. Properties of IRR Equation with Regard to Ambiguity of Calculating of Rate of Return and a Maximum Number of Solutions
Dan Hallett: Making sense of your new CRM2 performance report: http://www.theglobeandmail.com/globe-investor/funds-and-etfs/funds/making-sense-of-your-new-crm2-performance-report/article31876831/
Rudy Luukko: CRM2 won't solve tax-reporting headaches: http://cawidgets.morningstar.ca/ArticleTemplate/ArticleGL.aspx?culture=en-CA&id=692731
--
- Details
- Written by Glenn Szlagowski aka the Wealth Adviser
- Category: Newsletters
- Hits: 13274
Anatomy of a Financial Adviser – the real truth about fees and commissions
I was disappointed to read an article penned by a Canadian business journalist with impeccable credentials where the author in this article presented clearly biased information. In order to address bias or a temporary lack of journalism standards, I thought I would open the “books” wide open, and continue with my series of articles that divulges exactly what a financial adviser makes, how he makes it and let our readers decide if securities regulators should eliminate cheaper commissions, replace them with higher fees and force advisers to bill their clients.
I am “dual-occupied” adviser meaning that I am allowed to sell mutual funds as a financial adviser and also registered to sell GICs as a deposit broker. For mutual funds, I fall in the category as a “Dealing Representative” under the self-regulatory organization called the Mutual Fund Dealers Association (MFDA). As I work in the province of Ontario, the provincial securities regulator is the Ontario Securities Commission (OSC).
For GICs, I am also registered with the Registered Deposit Brokers Association (RDBA). The deposit brokerage role I have is considered to be an outside business activity (OBA) with respect to the dealer’s mutual fund business. Under MFDA guidelines, the two businesses must remain separate and distinct although there are guidelines under the MFDA that require the Dealer to monitor any approved “outside business activities” (OBA).
For some historical context about the “how and why” of front-loads, deferred sales charges and low-loads please refer to my fees and commissions guide.
I can describe myself as a zero commission adviser where for the last 15 years or so, I would waive my commissions so that I would charge a front-end load of 0% commission for the purchase of a new mutual fund. This does not mean however, that I am not earning any compensation!
I would earn anywhere from 0% to a maximum of 1.25% annual compensation depending on the type of mutual fund. For instance a stock based mutual fund would pay me 1.00% to 1.25% annually. The 1.25% ones are relatively rare and these are mostly mutual funds offered by the Canadian banks. A more typical remuneration for a regular stock based mutual fund is 1.00%. In general, a money market fund pays me nothing, a bond fund pays me 0.25%, and a balanced mutual fund pays about 0.50%.
An analysis of my book of clients indicates average remuneration of approximately 0.80% annually for mutual funds as I tend to lean to more equities (stocks) and use GICs as my bond (fixed income) replacement. I haven’t quite figured out my overall total asset-under-management commissions (under the current commission system) but it could be as low as 0.30% per year.
Where does this compensation come from and who pays it?
The remuneration is paid by the fund company to the adviser’s mutual fund dealer (the adviser’s head office) and then to the adviser’s branch. The adviser only keeps a portion of this remuneration. This percentage is called a “payout”. The Dealer deducts my expenses from my remuneration: licensing, postage, insurance software, etc. and the branch pays me a percentage of what is left. For GIC’s, I get paid by the bank.
How does the investor pay the adviser’s compensation (for mutual funds)?
The adviser’s compensation is built into the price of the mutual fund. The built-in compensation is disclosed and new changes in regulation means there will be even more disclosure in the future.
Despite all the increased disclosure, Canadian securities regulators are mulling over proposals to eliminate commissions entirely and imitate the U.K and Australia experience. If this happens, then all investors who wish to deal with an adviser would be forced to pay a discrete fee. The regulators feel that having separate fees and bills would ensure that investors would be fully aware of the cost of investing and the cost of their adviser. Although the regulators are aware that this will drive up the costs of investing they feel that the additional disclosure is worth the human costs and monetary costs (hundreds of millions?) to convert to a fee-based system.
Right now there are two different types of separate adviser compensation models:
- Commissions
- Fees
The Canadian Securities Administration (Canada’s possible, soon-to-be, national securities regulator) is proposing to ban all commissions completely but has not proposed a replacement. The industry is presuming that the only model remaining (fees) would be the favoured model.
[Editor’s note: With the choice of only the one option, the choice becomes self-evident.]
I have used both types of remuneration models –essentially the difference between the two is whether the adviser compensation is built-in (embedded and disclosed) into the price of the mutual fund or is charged separately to the investor as a bill/fee.
On paper, whether the fee is built in or not should not make any difference to the total cost to the investor. It would be the same as buying a wrench at Canadian Tire and having the tax built into the price of the wrench or the tax being charged separately at the check-out. The total price of the wrench – remains the same.
In reality, life is not so simple. Both models (commission vs. fees) will not be the same at the check-out. The problem with a regulator imposed fee structure is that you will be charged a fee on the whole account so that the low 0.25% and 0.50% commissions you may be paying now will be replaced by 1.00% (or higher) fees. In effect, you are replacing low commissions with much higher fees.
Additionally, many readers would be surprised to find out that if investors are forced to pay fees (if the proposed changes are approved) instead of paying commissions, your account must be of a minimum size. It depends on the firm but account minimums typically start at $100,000, $250,000 or higher just to have the privilege of paying for your adviser’s advice separately. If you don’t meet the minimum account size requirement then you won’t have access to an adviser and you will be left by yourself to figure out your own investments. Certainly these could be recipes for disaster especially for the young novice investor and especially for a senior investor who would need the guidance and wisdom of a financial adviser.
Business journalists and some investor advocates seem surprised that some advisers (myself included) do not want a substantial pay raise for doing the same amount of work and that dramatically increasing fees is plainly not fair to all investors. The brunt of the pain will be felt by smaller investors[1] who will be faced with the highest fee increases of all. And unfortunately, we advisers have very little say in the matter.
The sense I get from some investor advocates, the no-help mutual fund companies (Steady Hand, for example) and even the U.K securities regulator is that the demise of the small investor is merely acceptable collateral damage –a casualty of war whose losses are entirely acceptable. The thought often expressed is high net worth investors will be relieved of the burden of subsidizing the small investor and that the small investor will be cut adrift and left to their own devices to find financial advice.
In my personal view, I am completely aghast by such callous attitudes. Who speaks for today’s small investor? No one it seems.
As we already have openness and transparency in a commission based account, why would you say that higher fees are somehow more open and more transparent than lower commissions?
What is transparent to me is that the small investor gets kicked in the teeth.
To show how incongruent the press is on this topic, on the GIC side of my business I get paid by the embedded compensation built into the interest rate on the GIC. The built-in (embedded) compensation is paid directly to the adviser. Investors pay no fees to buy a GIC but the adviser is paid a commission paid directly from the bank. Exactly the same system used for mutual funds.
In a theatre of the absurd, to the press embedded and non-disclosed GIC commissions are perfectly OK, but open and disclosed commissions for mutual funds are not.
[Editor’s note: in the interest of full disclosure, I earn one time commissions for each GIC purchase of 0.20% to 0.25% per year of maturity on GIC business. Under the current commission structures, there are no ongoing management fees for GIC holdings; however there are no promises that under the new proposed fee model, those same GICs or other investments will remain fee exempt permanently.]
Bottom line, what is considered to be fair and equitable compensation to someone for managing one’s life savings?
In today’s marketplace, investors should expect to pay about 1% annually for advice. Higher net worth clients might pay less and under the newly proposed fee-based system, smaller investors (if they are allowed to even have an adviser) might expect to pay more – unfortunately – much more.
The solution to this adviser’s dilemma is surprisingly simple. We know that all commissions are completely disclosed and so are fees. Regulator concerns seem to be centered on some obscure fund companies paying much higher remuneration than average, perhaps as much as 0.75% higher. The existence of these very few marginal players appears to be the primary motivation to ban commissions for the entire industry. No one has apparently thought of an amazingly simple solution to address this issue:
Regulate adviser compensation or regulate the fund companies.
Instead of banning all commissions, why not regulate them instead? Cap them if necessary. Certainly, regulators at one time had no trouble in regulating commissions for stock brokers. Why not do the same for the mutual fund industry? Certainly it is within the mandate of a securities regulator to regulate mutual fund commissions.
In my view, if commissions are eliminated we will be left with the Wild West of higher fee structures. Fees will not be regulated and anything goes. The playing field will no longer be level. For the average investor, the human and monetary costs will be high – far too high.
--
[1] What is a small investor? It depends on who you are talking too. One describes a small investor as having less than several million dollars! Unfortunately, I don’t rub elbows with Warren Buffet or Bill Gates and yes for them, several millions of dollars is loose change that has fallen between the seat cushions! Since there is no definition per se, I will have to make one. If you have less than $100,000 in securities then you are a small investor.
Related articles:
http://wealthadviser.ca/newsletters-8/205-big-changes-mutual-fund.html
http://wealthadviser.ca/newsletters-8/230-fees-commissions-which-one-is-better.html
http://wealthadviser.ca/newsletters-8/218-a-short-history-of-mutual-fund-fees-and-commissions.html
http://wealthadviser.ca/newsletters-8/214-a-fee-is-a-fee.html
http://wealthadviser.ca/newsletters-8/209-more-discussion-about-fees-and-commissions.html
http://wealthadviser.ca/newsletters-8/203-adviser-fees-the-pain-of-paying.html
- Details
- Written by Glenn Szlagowski aka the Wealth Adviser
- Category: Newsletters
- Hits: 7993
Small investor mutual funds – can they continue to exist?
Mutual fund investors that hire financial advisers to manage their life savings have two choices to pay their adviser. They can have the adviser’s remuneration built-in the cost of the fund (all inclusive) or they can buy the same fund and pay the adviser directly (a fee is deducted quarterly from your account).
Which one of the above two adviser remuneration models is cheaper?
Neither –at least on paper. Presuming your fees are tax deductible (they are not for RRSPs, RRIFs and TFSAs) the fee-based account turns out to be the exact same cost as in the built-in (embedded) cost model.
In reality, the fees in a fee-based account will likely be considerably higher due to the fact that you are replacing 0.25% and 0.50% commissions on income and balanced mutual funds with a higher flat fee of say 1% per year.
Therefore, if you currently own bond funds, balanced mutual funds or any sort of income fund, your total direct costs may double or in some extreme circumstances – quadruple!
Still, the regulators seem bound and determined to replace lower commissions with higher fees. Advisers have seen the writing on the wall and have come to the sinking realization that they have lost the battle to keep their low commission structures and will be forced to charge higher fees while doing the same amount of work. Advisers are not willing to wait much longer for proposed regulatory changes to come into effect or wait for yet another study that may or may not result in a ban commissions in the mutual fund industry.
Advisers, although reluctant at first, have decided to convert their clients to the only option that will be left to them – a fee-based model. The initial trickle has since turned into a flood.
As the tsunami to asset based fees continues, revenues from fund companies to dealers will continue to drop and be replaced by increased internal AUM (asset-based fees).
Many advisers are transitioning their larger clients to fee-based accounts first. As the business of advising goes “upscale” and likely to proprietary in-house managed product solutions, dealers are also looking at algorithm based solutions for “small” clients that do not qualify for fee-based accounts. However the proposed fee structure for “advice-lite” type of accounts is unknown.
The fate of the small investor (less than $100,000 in securities) is still largely unknown. In a previous article I felt that the fee-based model will have a very detrimental effect on small investors as it appears that the small investor will be abandoned and left to their own devices to find help with their investments.
Abandoned by the regulators and with advisers helpless to interfere, small investors appear to be handed the wrong end of the stick in what I had described as a “casualty of war” and ‘acceptable collateral damage”. However there might be a slim glimmer of hope left for small investors.
Mutual fund companies to the rescue?
Investors and even many industry insiders are not aware that there is an alternative for small investors to consider should the Canadian Securities Administration ban commission based accounts.
There may be a choice after all.
Some mutual fund companies have had fee-based accounts for a number of years but they were rarely used. The advantage of these accounts is that:
- The fee is completely negotiable between the investor and the adviser.
- There are no account minimums!
- They retain a client-name structure which means that unlike nominee plans where the securities are held directly at the investment or mutual fund Dealer, there are no annual fees, no unscheduled withdrawal fees, no transfer-out fees and no multi-plan fees.
- Full access to a financial adviser.
There are some what I would describe as accidental benefits to client-name fee-based accounts:
- Regulators are determined to stamp out all commissions at all costs. This structure will effectively “get rid commissions” and replace them with equivalent fees. Regulators, journalists and other groups can claim a moral victory in that they can claim they have eliminated evil commissions and trailers and replaced them with something else (fees).
- Zero commission advisers can effectively keep things as they are. An adviser earning an annual trailer of 1% can replace it with an exact 1% fee.
Discerning readers might ask the question: Why replace commissions with fees if it comes out to the exact same thing? That’s a great question and is one that an investor might ask at the next public townhall meeting.
- Details
- Written by WealthAdviser
- Category: Newsletters
- Hits: 11130
Beware the passive-ists – they bear false gifts
Passive investing proponents hold on to the belief that advice is irrelevant. One merely needs to invest in an index. I refer to this class of believers as “passive-ists”.
Lately, I am seeing with increased frequency many articles, newspaper articles, even forum comments all concluding that passive investing clearly outperforms active investing because it is cheaper. And that mathematically and empirically, cheaper investments always do better.
Such reports are accompanied by charts of comparing various investments to, usually, a stock index of some sort. The chart, of course, always shows the index in the lead. The accompanying article would also include a calculation indicating if you dump your financial adviser and save 1% a year, you will save thousands of dollars over your lifetime and your portfolio will be guaranteed to outperform everyone else.
Sheer rubbish of the worst kind, I say.
It looks like another outbreak of cognitive dissonance[1] has broken out once again. It is similar to the belief that American real estate could never, ever go down in value and that banks really have no need for collateral on a mortgage because a house, any house at all, could be sold or foreclosed for that matter, at an enormous profit because a house’s rise in value was infinite.
Unfortunately, the sub-prime collapse and subsequent housing collapse of 2008 destroyed the widespread cognitive dissonance of the time along with a trillion dollars or so of real estate values. The existing “beliefs” and “truths” were completely and utterly destroyed. Millions presumed that residential real estate could never fail. The U.S. Financial Crisis proved them wrong. What was oblivious to millions of homeowners became immediately obvious to all.
Investing fads come and go. Nobody wanted to be in the S & P 500 index when it dropped -57% five and a half years ago but right now, everyone wants to be in that same S & P 500 stock index today merely because it is cheaply traded, can be traded on a smart phone and according to the press, we can manage our life savings entirely by ourselves without any help.
The truth is the do-it-yourself investors will abandon the index investments in a panic liquidation during the next financial, political, economic crisis as easily, quickly and cheaply as they had acquired them in the first place. These “no-help” investments will cut the deepest as cheapness, in the end, has a price. That price may be your retirement, the family’s life savings or a relative’s portfolio you were managing. And the very last thing you will be thinking about is how much money you saved.
Currently, investors are pouring billions of dollars into index-like investments. Buy and hold strategies used to refer to long term investments like mutual funds that were held for many years. Today, long term means 20 minutes. The collapse of trading commissions – practically almost zero these days – means that we can buy and sell investments using our smart phones, cheaply, instantly and with scarcely a thought.
That’s the scary part, buying and selling investments without thought.
Active investing refers to investing with an adviser. Passive investing usually refers to investing in some sort an index-related investment.
It is true that when a stock market index is soaring (like right now), active investing with an adviser is sure to lag. All advisers know this but the press or other “experts” somehow have acquired beliefs that advisers should match or beat the index at all times.
This is where the affliction called cognitive dissonance comes into play. This affliction or disorder affects many people - even really smart people that should know better. Most unfortunately, but most obviously, some “experts” base their charts and tabular numbers, spreadsheets and assume (without giving much thought) that 100% of all investors will receive 100% of the return of the index 100% of the time. They conclude that a fee (any fee) by an adviser will commensurately and absolutely reduce the rate of the return by the identical amount.
What sheer lunacy!
The “experts”, writers and journalists overlook the obvious; do-it-yourself investors have and always will actively mismanage their passive investments and therefore, investors will not achieve index returns as they trade in and out of the investments. In the long term (the last 20 years), the average rate of return is almost at the bottom of the scale. It is scarcely that of cash. And no, the difference in numbers is so vast that we can not blame mutual fund fees or MERs! See this astonishing chart below:
Invesco, a well known and respected Canadian mutual company, says it is having difficulty finding value in the lofty stock markets and are expecting to build cash reserves. Invesco could be right or wrong but they are quite happy to keep some cash in reserve for better bargains (perhaps after a significant stock market correction?) Will they underperform the index while investors pile in at the tippy-top of the market? Yes they will.
At the time of writing (September 2014), the index is soaring to all-time record highs. Millions of investors are pouring hot money not into actively managed mutual funds, but into index-like products that emulate the benchmark indices.
Are the markets euphoric or merely complacent? Will bonds plummet in value when interest rates are set to rise once again? Do clients have too much stock exposure? We have not had a normal 10% stock market correction since 2011. Volatility has been quiet for some time – maybe too quiet.
I think it would be prudent to do a portfolio review and start exploring some of these questions.
Call your adviser today!
[1] Cognitive dissonance: technically it is a psychological condition, but in modern usage it usually refers to “being oblivious to the obvious”.
- Details
- Written by WealthAdviser
- Category: Newsletters
- Hits: 10881
Fees or commissions – which one is better?
It depends.
Sorry for the cop-out, but today’s raging controversy about whether we should ban commissions and move entirely to a fee-based system (like in the U.K and Australia) has become a tug of war pitting one system versus the other.
The anti-commission, pro-fee crowd firmly believes that commission of any sort skews investment recommendations and that mutual fund commissions should be banned permanently. I disagree with the conjecture by some that commissions skew investment recommendations.
The pro-fee crowd believes that handing a bill to a client for managing mutual funds on a quarterly or monthly basis is the one and only path to enlightenment.
The annual fee is usually a percentage of assets under administration (AUM). A typical fee for a $250,000 mutual fund account might be 1% annually. One percent of $250,000 is $2,500 which means you will be billed $625 every few months. The fee collected does not all go to your adviser. The adviser typically might be on a 50% “payout”. At this 50% payout level she earns $1,250 but has to pay head office expenses, licensing fees, client statement fees, regulatory fees, etc. She might only get a portion of those total proceeds as the remuneration is split out to the adviser’s firm and the branch she works for.
Unfortunately, the adviser’s costs and expenses are not disclosed and this is a shame as most investors should know where all this money really goes to.
From the client’s perspective, you still have to pay the amount even though in previous years this 1% or $2,500 was built into the price of the product. In other words, the 1% was all inclusive. The regulators are proposing that the 1% built-in fee should be replaced by a bill of the same amount to the client.
So which system is better? Build the 1% into the cost of the product or charge 1% less for the product and then send the client a bill for 1%? (Assume all costs for either model are fully disclosed.)
From a mathematical perspective, reducing the product’s price and then adding the same amount back is a wash.
To the client not much changes; you are still paying the 1% in either model whether it is separated out from the product price or not.
The regulators are favouring the 1% bill model as they feel it is better for all clients.
I say –not so fast!
As an adviser, I am currently earning annual remuneration anywhere between 0%, 0.25%, 0.50%, 1.00% and 1.25% depending on the type of fund in the portfolio. The breakdown is this:
I earn 0% annual remuneration for GICs and money market mutual funds, for bond funds I would earn 0.25%. For balanced funds, I would earn 0.50% and for equity mutual funds I would earn 1.00% to 1.25%. Depending on the adviser’s asset allocation, the average compensation (excluding GICs) might be 0.80% or it could be a great deal less, especially if you do not have much in the way of equity mutual funds or do a lot of GIC business.
Do you see what the problem is? If the regulators ban commissions, I get an instant pay raise of at least 25% or more! And the regulators will force clients to pay the increased fees.
There’s nothing wrong with getting a pay raise if you deserve it but here is my point; I will be doing the same amount of work but I will be getting a 25% pay increase. Ironically, the pay raise will come courtesy of the regulators!
Reducing choices and increasing costs at the same time should be raising some eyebrows and certainly should be raising some questions. Not everyone has $250,000 to qualify to have an adviser and be charged a fee. What about new investors just starting out in life – recent graduates or young families? Will that market segment have $250,000 just to have the privilege of paying a new fee?
Commissions have the advantage of being transaction based and are not dependent on account size. In most cases, today’s commissions will be lower than the proposed higher fees in the fee-based accounts that the regulators seem to be favouring.
My vote is to keep the current two-tier system and let the client choose the appropriate model. I am all for reform, but limiting choice, inflicting monetary pain and excluding many thousands of Canadians from financial advice is not my idea of reform.
Instead, I would simply propose that commissions be capped by the regulators. If the renumeration is the same for everyone, then “skewing” or even the faintest temptation to skew investment recommendations would be completely eliminated.
