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:

1. The fee is completely negotiable between the investor and the adviser.
2. There are no account minimums!
3. 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.
4. Full access to a financial adviser.

There are some what I would describe as accidental benefits to client-name fee-based accounts:

1. 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).
2. 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.