Tuesday, September 9, 2014

Embedded Commissions: Mutual Funds vs. Cars

A very clever argument used by those who want to maintain the current embedded commission model for financial advisors goes as follows:
When you buy a car, you don’t demand to know the size of the salesperson’s commission. So, why would you demand to know the commission your financial advisor gets?
Most other arguments the mutual fund industry uses are easily refuted (see Tom Bradley’s excellent article on this subject). However, this car analogy rings true at first. I don’t worry about how much commission the car salesperson gets. It’s the total price of the car that matters to me.

The problem here is that the analogy isn’t an exact fit. For example, almost everyone is aware that car salesperson commissions come out of the car price. Many investors don’t know how their financial advisor gets paid. But the differences run deeper.

Let’s imagine a fictitious world where car ownership more closely matches mutual fund ownership. Suppose that instead of paying car salespeople from the car’s price, car companies sneak out in the middle of each night and siphon a few dollars of gasoline from all the cars they’ve ever sold. The car companies resell this gas to pay salespeople commissions and their own salaries. Many car owners aren’t aware that gas siphoning goes on, and even when they hear about it, they don’t believe it’s happening to them.

All this may sound absurd, but it is a close analogy to how most mutual funds work. The management company takes cash out of the funds each day to cover all costs including financial advisor commissions. There are some mutual funds that don’t pay financial advisor commissions, but most do in Canada.

In this fictitious world, it would be perfectly reasonable for car buyers to ask salespeople whether they are paid from surreptitiously-siphoned gas. They might also ask whether salespeople recommend cars based on their cut of the gas siphoning.

Getting back to the real world, it’s true that mutual fund investors should be concerned primarily with total costs rather than just their financial advisor’s cut. But, in most cases, investors’ only contact is with their advisors, and mutual fund companies are paying advisors to make them insensitive to the total fees of the mutual funds they recommend. The problem is not just the hidden costs of financial advice, but the inflated costs not associated with advisors.

If we cut off the flow of money from mutual fund companies to advisors, this will remove the incentive of advisors to choose expensive mutual funds for their clients. This will force more mutual fund companies to compete on costs, which will be very good for investors.


  1. Good post Michael. I probably would never start any debate on this issue with your opening quote because the two are not comparable. Financial advisors should be held to a higher standard than general salespeople. The industry's disclosure is, accordingly, well ahead of what you find in the retail world - whether we're talking about cars, clothing or electronics.

    I also support the idea of giving people a choice of how to compensate their advisors. But this requires clear and meaningful disclosure - which the industry has been fighting. As I wrote 18 months ago, the industry had a choice to come clean on full disclosure - which would avoid a commission ban in my view. But continued road-blocking of client-friendly initiatives will bring on commission bans that the industry is fighting so hard to avoid.


    Dan Hallett

    1. @Dan: I'm not opposed to a workable compromise, but I think its likely that the only way to force genuine disclosure is with an outright ban on payments from mutual funds to advisors.

  2. Great post Michael. As you referenced, the car purchase is a one-time transaction, or at least, a transaction every 10 or so years. It's not the on-going pay-at-the-pump bleeding money issue.

    People wouldn't overpay $10 for a pizza on Friday night, yet millions of Canadians are unknowingly paying thousands of dollars in embedded fees each year. This makes no sense to me.

    I think the wake-up call isn't about financial advisor fees alone, it's about recognizing the total costs of running a portfolio.

    Start with the big picture, then work your way to the details from there otherwise the details will tune people out.


    1. @Mark: Thanks. Vanguard's mutual funds in the U.S. are proof that even actively-managed funds can be run cheaply. We don't have the scale in Canada that Americans have, but there is still a lot of room to reduce costs in Canada.

  3. Interesting analogy. I am curious to see how the mutual fund industry evolves and there are more requirements on the disclosure of fees. Do you think more people will continue to lean towards lower cost ETFs?

    1. @Dan: I can't predict what others would do, but my total costs of MERs, trading expense ratios (within ETFs), commissions, spreads, and foreign withholding taxes is under 0.2%/year. It would take a dramatic drop in mutual fund costs to compete with this. So, I'm not likely to move away from ETFs.

    2. Michael - The TD e-series are that dramatic drop to me. The difference in MERs is largely offset by transaction fees and other 'frictional costs' - I think CCP calculated the money came even around 50K, but with other benefits to the index mutual fund (easier rebalancing, bid-ask, etc). If the bulk of my retirement savings wasn't in a DB plan (my contribution is 10% gross), I would be more likely to consider going discount brokerage. I do find it strange that TD has these great products but make it very difficult to access, obviously they have many thousands of reasons to want people at least in their i-series index funds instead of e-series.

    3. @CraigM: I guess it comes down to how much you trade, but my list of "MERs, trading expense ratios (within ETFs), commissions, spreads, and foreign withholding taxes" includes all frictional costs I can think of, and I'm still well under 0.2%. So, TD e-Series MERs would have to come down significantly to compete. Your mileage may vary.