Wednesday, December 14, 2016

Why Do We Focus on Advisor Cost?

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.

6 comments:

  1. Dan Hallet at Highview Financial Group sent me the following comment:

    Your blog suggests that most advisors give in to the temptation to sell higher commission products. In my experience, while advisors clearly have an aversion to no-commission products (because commissions are their payment mechanism) I'd say that most advisors try to avoid selling the higher-commission product. When some funds offered bigger up front commissions than other similar funds in the past, there were a few that loaded their clients up on high commission crap. But a strong majority preferred to avoid the perception of conflict that would result from selling the same higher commission product.

    The more subtle conflict is the subconscious 'pressure' to view products as indifferent; in which case an advisor could view the higher commission product as the better choice if s/he is otherwise indifferent between the two. This is where the advisor needs to scrutinize better and where there could be an implicit tendency to view higher commission products as just as good or better than others.

    But no doubt that CRM2 will help not only keep fees and commissions in check; but over the past year or more it's already been exerting downward pressure on product fees.

    One fund co after another has announced automatic tiered pricing (based on investment amount); lower series of units; D series units; lowering of management fees; lowering of higher than normal commission rates; etc. This has been happening across the industry for a couple of years - and I believe that a big trigger has been CRM2 and the disclosures that will come with it - imperfect as they are.

    ReplyDelete
    Replies
    1. @Dan: Thanks for the insights. It's true that I gave the impression that advisors recommend whatever pays them the most. In reality, they are really just avoiding the ones that pay less than the "standard" amount. However, "standard" advisor commissions and trailers are very high.

      I'm hopeful that CRM2 will make a difference.

      Delete
    2. Is Dan for example referring to something like the letter that I received from TD bank declaring they were lowering their fee's for a broad selection of their funds? Or similar offering elsewhere? The whole 1/10th of 1 % average drop? I just shook my head when I saw it... Really none of the fund names you would see in a list of their top performers as well. I would say its just so they could try to gain favor by just "saying" they lowered fee's.

      Delete
    3. @Paul: I can understand your frustration with high fees. No doubt most mutual funds would rather not lower fees, and if forced to, would try to lower them by as little as possible. This is likely what you're seeing. If CRM2 does its job, you should see more reductions in the future. But I'm not making any predictions.

      Delete
  2. I wonder how hard it would be to write a tool that ran through a mutual funds holdings and give standard deviation from the Major Indexes for the fund (i.e. how closely do they mimic a specific index (and maybe compare over time too)). The tool could then compare the MER to a similar Index Funds MER? Just an idea (should be relatively straight forward).

    ReplyDelete
    Replies
    1. @Big Cajun Man: What you are describing is a measure of deviation from the index called "active share." I've seen various things written about active share, but I don't know how easy it is to find the active share of a particular mutual fund. It would certainly be good if mutual fund websites included active share along with MERs and all the other information they give about mutual funds.

      Delete