The cost of purchasing and maintaining ownership in a mutual fund is an important consideration; one that an investor must weigh carefully before choosing which mutual fund option they will invest in. There are different kinds of mutual fund fees, and we will go over them in our two part series starting with some transaction fees and sales charges.
Mutual fund basics
A mutual fund is basically a collection of stocks and/or bonds managed by a mutual fund manager. Each person that invests in a particular mutual fund becomes an owner of units in the mutual fund, which in turn owns the underlying securities. In theory, mutual funds should be a sound investment… after all, your money is being managed by a professional, right? One of the issues with mutual funds lies in the many types of fees that may apply. Understand these fees and ask questions; if your fees are going to eat into a substantial portion of your return, you will need to think twice about your investment choice.
Transaction fees and sales charges
Transaction fees and sales charges vary considerably depending on the mutual fund you choose, who is managing it and how often you carry out transactions. Those who buy their individual stocks on the open market will pay a fee to their brokerage each time – more buying and selling means more transaction fees. Mutual funds aren’t much different. There are a range of transaction or purchase fees to be aware of, and any given mutual fund will likely come in a range of flavours, each with different fee structures. Initially, providing multiple fee structures was intended for financial advisors, so that they could sell their client the fee structure most palatable to them. In the age of fee-based advising and discount brokers, fee-based or no-load funds tend to be most popular.
Front-loaded sales charges
Sometimes called front-end or initial sales charges, a front-loaded mutual fund charges a sales fee, really, a commission, every time you purchase units in the fund. This charge is quite comparable to a trading commission for an individual stock, and the arithmetic of how it impacts your return is simple – if the front-loaded sales charge is 3%, that’s $3 of a $100 mutual fund purchase, and now, to earn that back, the fund needs to return a net amount of 3% to you in order to make that up. A 3% charge isn’t abnormal. The front-loaded sales charge is paid directly to your financial advisor. Therefore it figures that if you don’t have an advisor, but rather, you use a discount broker like Questrade, you won’t pay a front-load commission (Questrade and other discount brokers will charge you a small fee to transact, but it tends to be a fixed dollar amount, so that a large investment reduces this fee to a negligible amount). However, with front-loaded funds, there can still be trailer fees, which we’ll explain later.
Deferred sales charges
Sometimes called back-end-load sales charges and generally abbreviated simply “DSC,” these charges have come under a lot of fire over the past fifteen years and are less common than they were two decades ago. These fund types charge no fee when you purchase them but will charge you a percentage of your total asset value in the fund if you sell too early. Typically the DSC is around 6-7%, but decreases by a percentage point every year, so that if you hold the fund for six, seven or more years, you pay no DSC once you sell (redeem) after that time. The idea here was to motivate investors to stay invested, stay disciplined and on track (something we actually think is really important) and let their money work – and for the fund manager to earn their management fee (more on that on our next page). However, this half-noble cause was often poorly explained by a mutual fund salesperson, and a naive investor might have a change of heart a year or two after purchase, only to get hit with a fat DSC charge when they redeemed their fund. We think the bad press is part of the reason DSCs have died out. (As a side note, if there’s no DSC, how does the salesperson get paid? What happens with DSC is that when you purchase the fund, the fund manager pays that salesperson that DSC amount from their own pocket, and they make it up through their ongoing management fees, or, by dinging you if you redeem early. So in a way, the fund manager is paying the salesperson with the assumption that you’ll stay invested with them long after the salesperson is out of the picture.) DSC funds also charge trailer fees, but typically lower ones than front-loaded funds.
Low-load sales charges
Something of a combination of a front-load sales charge and a DSC, a low-load sales charge tends to be some smaller percentage when you buy, perhaps 3%, and then a deferred sales charge if you sell too early (e.g. 3%, dropping by 1% for every year you hold the fund). Again, these amounts go to your advisor or salesperson. Low-load funds can also pay trailer fees to advisors.
As noted above, now one of the more popular options. No-load simply means there is no front-end or back-end sales charge. But there are still costs to the investor, and the salesperson still gets paid. Part of the MER (Management Expense Ratio) you pay is a “trailer fee,” which goes to the salesperson. No-load stings a lot less, but it still requires a pretty hefty MER to justify the fund existing at all. No-load funds are what Questrade and other discount brokers typically sell.
As far as actively managed funds go, this is our preferred way to own them. However, these will only be available to you if you deal with a “full-service” advisor, like someone at CIBC Wood Gundy or Richardson GMP. (Fee-based advisors negotiate a percentage of assets that they charge annually, and you pay nothing, (or next to nothing) for the actual securities or funds in your portfolio. Fee-based funds do have an MER, but they pay nothing to the advisor, so the cost is the lowest possible.
Now that we’ve looked at purchase or transaction mutual fund fees in all their flavors, let’s talk about management expense ratios, or MER, and associated fees, including trailer fees.