The topic of fees is often a hard one for investors to wrap their heads around. Specifically, how much do you pay for the advice or services that you receive? In the financial services industry, it is easy for investors to ignore how their financial advisor is getting paid for the work they do because out of sight truly is out of mind. They know that their advisor is getting paid but, unless they have a fee for service arrangement, the client often doesn’t know how much the advisor is making, particularly if he or she is using mutual funds or managed money in their investment portfolio.
This is a hot topic that is front and centre in the eyes of the financial services regulators here in Canada and there will continue to be a great deal of discussion about the transparency of fees charged in the investment industry as new rules are introduced to unveil exactly who is making money off of your investments and how much. While there are no defined limits on possible returns that can be made in the stock or bond market, fees that are charged to generate those returns can have a negative effect on the net returns generated for the investor and the higher the fees, the lower the net return.
When using managed money to build a portfolio, an investment advisor can get paid in a variety of ways. They can charge an annual portfolio management fee (also known as fee for service) where they may charge (for example) 1 to 1.5% of the value of the account held with them. They may instead charge up-front fees where they charge a specific amount or percentage of the funds when they are first invested (usually anywhere from 0 to 5%) and then receive an ongoing service or trailer fee from the fund company the funds are invested in. They can get paid by charging what is known as a back-end load, where the company they place the money with provides them with a commission based on a percentage of the funds placed with the firm – also known as deferred sales charge and then also receive a reduced ongoing service or trailer fee from the fund company.
In each of these scenarios, the mutual fund will have a management expense ratio (MER) that reflects how the advisor gets paid. The MER is a total of costs to run the fund, or administration costs, and service fees that are paid to the advisor. It is the service fees that are creating most of the buzz around the transparency of fees and no matter how you slice it, if you are working with an advisor, that person has got to be paid for the service they are offering. The key here is how much should they get paid and what is the value that should be placed on the advice they are providing.
It seems that whenever the discussion turns to fees, many investors ask their advisor to invest their money in ETF’s (Exchange Traded Funds) instead of mutual funds because the ETF’s typically have much lower management expense ratios than managed money has. An ETF is a collection of stocks or bonds (or other investments) that mirrors an index such as the Canadian stock market or the US stock market and, while they typically have lower administration costs, the jury is still out as to whether or not they are a less expensive investment vehicle when all transaction costs are taken into account.
Regardless of which investment vehicles are chosen – funds, stocks, bonds, or ETFs, the costs you are paying should not be the only factor in deciding how you should invest. The most important consideration is how much money you make.
Doug Riding BA, CFP®, FMA, FCSI®
Senior Investment Advisor with IPC Securities Corporation