Canadian investors have a problem. The mutual funds they own typically charge 2-2.5% of their savings (not just returns) each year. Over an investing lifetime, these hidden costs can consume as much as half of their savings, leaving them with half as much retirement income. You’d think that investor advocates would be calling for lower-fee mutual funds instead of just focusing on the part of the cost that goes to financial advisors. But there is method to this madness.
The second round of changes to the Client Relationship Model sets out rules, known as CRM2, mandating that reports to clients include, among other things, clear information about the dollar amount clients pay to their advisors. But there is no such requirement concerning the other fees that mutual funds quietly withdraw from investor savings.
This may seem like an oversight, but it is actually a targeted measure. To see why, we need to back up a little. A great many mutual funds, particularly the largest ones, do not seriously try to make market-beating returns. They are actually what are known as closet indexers. They own a portfolio of stocks and/or bonds that closely match stock and bond indexes.
You may wonder how such funds can expect to attract investors if they aren’t even trying to be the best. To begin with, they eliminate the risk of making bad investments and being among the worst mutual funds. Their other strategy is to pay financial advisors commissions and yearly trailing fees for steering clients into their mutual funds.
Some financial advisors resist the temptation to recommend mutual funds based on how much the advisor gets paid, but a great many don’t resist. So, this strategy works for mutual funds wishing to pump up their assets under management.
A disadvantage for these mutual funds is the lost revenue that flows to advisors. To compensate, the mutual funds set high Management Expense Ratios (MERs). The MER is money quietly removed from investor savings continuously. Closet indexers with high MERs are soaking their investors with high fees and are splitting the spoils with financial advisors.
If CRM2 can make advisor pay more visible, the hope is that their clients will start paying attention to these costs. If advisors are forced to limit themselves to reasonable fees, they won’t have any incentive to recommend poor mutual funds that happen to pay big commissions and trailing fees. So, if CRM2 has the desired effect, high-priced closet-indexing mutual funds will have trouble attracting investors.
Whether this strategy will work or not remains to be seen, but at least there is a rationale for shining a light on advisor costs when it is actually the total cost of investing that matters.