A financial advisor sent me an email after reading my column in The Globe & Mail titled, Would you give up 44 per cent of your investment over 25 years. It was actually one of the more cordial emails from financial advisors who were not happy with the column. I decided that I would publish his email on the blog in its entirety and address his points for all to see. I’ll use “Financial Advisor:” and italics to indicate the text from his email, and I’ll reply with “Preet:” and non-italicized text.
FINANCIAL ADVISOR: I am confused. Here I am, having been in mutual funds since 1994, a CFP since 1998 and all of my clients have more money than they have invested. In the financial press it would seem that 2.5% is a commonly accepted MER and if I keep the maths extremely simple, then clients would lose 25% over the course of 10 years.
PREET: I agree that a 2.5% MER is probably too high of a number to use in general. According to Dan Hallett, Director of Asset Management at HighView Financial Group, the asset-weighted average equity fund MER in Canada was roughly 2.26% in 2009. However, as a counter point, a particular fund that has been dissected in the media lately was Canada’s largest mutual fund with almost $13 billion in assets and an MER of 2.69%, the Investors Dividend Fund. There are plenty of funds with MERs over 3% as well, and in the context of highlighting the importance of fees, using 2.5% is completely defendable. Having said that, the Globe column example in which 44% (44.96% to two decimal places) of the potential value being consumed over 25 years was cited was based on an MER of 2.36% as I randomly selected a fund to use. Had I used a 2.26% MER fund, an investor would give up 43.53% over 25 years. Not a material difference. Had I used the Investors Dividend Fund MER of 2.69% an investor would give up 49.42% of their potential portfolio value, and a fund with an MER of 2.50% would give up 46.90%. You can calculate values for your own funds’ MERs using a spreadsheet I created here.
You state in the last line of this section that keeping the math simple means “clients would lose 25% over the course of 10 years” using a 2.5% MER value. I think it would be more precise to say they are “giving up” 21.12% of the potential value of the portfolio over 10 years. The equation and explanation are clearly provided in the column (note especially the comment of Michael Wiener, author of one of my favourite blogs Michael James on Money, on why the increased frequency of compounding slightly benefits the investor to understand why 2.5% does not translate into 25% over 10 years). I think you are confusing the argument of the negative effect of fees on performance with “fees = negative performance” somehow.
FINANCIAL ADVISOR: If I am to keep things very simple my clients would lose 2.5% of their funds each year in order to lose 25%. But why have my clients got more money than they have invested?
PREET: Because the gross performance of the funds is greater than the MERs.
Gross performance of a fund is the performance before fees. If a fund returned 5% before fees and had an MER of 2.5%, then using simple math the fund’s return net of fees would be +2.5%. All mutual fund returns in Canada are reported net of fees.
FINANCIAL ADVISOR: Perhaps it is because no mutual fund earns a return of 0% each year and then deducts the MER.
PREET: This could happen. If the gross return was 0% per year, the net return would be -2.5% per year. I’m pretty confident that given all the funds out there, I don’t even have to look it up to tell you this has happened in the past.
FINANCIAL ADVISOR: Perhaps it is because the MER is deducted from the return for the fund and then there is a posted rate of return.
PREET: Nowhere in the column or associated blog post does it suggest otherwise.
FINANCIAL ADVISOR: In some years, during the past 16 there have been negative returns but, in the majority of the these years, the returns have been positive. When a mutual fund posts an annual return of 4.5% and the MER is 2.5% it means that the manager/s of that fund had an actual return of 7.0%.
PREET: No arguments here.
FINANCIAL ADVISOR: While I will agree that it would have been much more pleasant to receive 7.0% than 4.5%, how can you argue that the annual MER automatically reduces the value of a person’s portfolio?
PREET: Because it does.
The MER is subtracted from the NAV of the fund. Hence, it reduces the value of the fund. I’m not sure how you could argue otherwise.
FINANCIAL ADVISOR: When an American investor (for example) places his/her money in mutual funds are there any costs? And if so, what are they?
PREET: I’m not sure of the relevance of this question, but: Yes, there are costs. They are very similar in nature to Canadian mutual fund fees, but generally lower in value. There are two main categories of fees: 1) Shareholder Fees (Sales loads, Redemption Fees, Exchange Fees, Account Fees and Purchase Fees) and 2) Annual Fund Operating Expenses (Management Fees, 12b-1 fees which are distribution and/or service fees, and Other Expenses which are comprised of custodial, legal, accounting, transfer agent, and other administrative fees). For more information, you can visit the Securities and Exchange Commission’s website for a more detailed explanation.
FINANCIAL ADVISOR: Many of my clients are ordinary working people who earn less than $60,000 per year (some, a lot less) and I meet them after work in their homes. I don’t know what happens in the USA but in the UK (where there are now no commissions to be charged) people rarely see their advisor; business is conducted over the phone or internet.
PREET: Many financial advisers in The United Kingdom meet with clients at their offices or at their clients’ homes after hours, as described on firms’ and advisers’ websites. Also, a cursory look at financial adviser job postings indicate candidates can expect to work evenings and weekends, meeting with clients face to face on a regular basis at various locations. If you have any evidence to support your claim, please provide it.
FINANCIAL ADVISOR: I live off the trailer fees that I receive from the mutual fund companies I deal with, and – no – I do not choose those fund companies or funds which give me higher trailer fees.
PREET: That’s good, because I know of a lot of financial advisors who are swayed to use products based on higher commissions that are attached to said products without being transparent about the conflict of interest to the client.
FINANCIAL ADVISOR: My plans are prepared – with integrity – free, my advice is free and I am not allowed to be fee-based and also collect trailer fees.
[NOTE TO READERS: I added the underline emphasis above - Preet]
PREET: Your advice is not free. It is deceitful to imply this as you would not provide financial plans if your compensation was not provided by the products you sell. The expenses embedded in the products are the source of your compensation, and you may or not be disclosing to your clients that part of the fees embedded go to you, but they’re there.
FINANCIAL ADVISOR: Anyway, fees are only tax deductible for non-registered accounts (goodbye RRSPS, RRIFS and TFSAs) and how would I charge fees to a young person starting out with an investment of $50.00 per month? Or should I wait until the people I contact (and then can call clients) have at least $50,000 tucked away and then I can charge them 1% per annum?
PREET: Firstly, it is important to understand that Client Advisory Fees are “potentially” tax deductible for fee based arrangements, while MERs are never tax deductible for the purposes of a client’s tax return. I wrote about this recently here and encourage those not familiar with the distinction to read more about it. Secondly, tax deductibility of expenses should not be the sole dictator of what types of investment accounts to use, and some would argue that using a fee-based advice arrangement with a tax-sheltered account is still valuable since the fees are more transparent, which is the real argument.
I feel you’ve completely missed the point of the column. It was not suggesting that everyone use a fee-based advisor at all. It was about transparency and providing clients with information that may impact their decisions. Right now, there is no reason to bypass a young investor who only has $50/month to contribute if all you are arguing over is hidden fees versus fee-based advice relationships. Go ahead and explain to them that you are using a Deferred Sales Charge mutual fund with an MER of 2.75% (as an example). If you’re transparent about it, they’ll see that (assuming a 5% DSC commission on new money and a 0.5% trailing commission and straightline market growth of 5%) that in the first year you are only making $31.64 before payout and maybe $22.15 after the payout (assuming a 70% payout rate) to provide advice and further, they’ve only paid $9.34 from their portfolio in expenses (assuming no account fees). Compare that to a 1% per annum charge which would have been $3.30 for that first year (assuming any dealer would allow it) and chances are they’ll be happy to let you charge them for a DSC on a high MER fund because at low asset levels, even relatively expensive mutual funds are low cost on an absolute basis. No one expects a professional financial advisor to work for free.
I don’t have any issues with the existence of DSC, high MER funds. I have an issue with a lack of transparency that allows for DSC, high MER funds to be used with clients who have more than a few thousand dollars invested because they don’t know any better. Because the truth is being purposely hidden from them by an industry that is in the business of providing financial advice. Last time I checked, fees one pays is a financial matter.
At some point that young investor could become a big investor, and with transparency and an advisor working in the client’s best interest, a switch in fee model, product or something else is an eventuality.
FINANCIAL ADVISOR: Back to the main point. Please give me an example of a mutual fund which has consistently reported a rate of return of -2.5% (i.e. actual return minus the MER).
PREET: I’ll humour you, even though this has nothing to do with the point of the column. A Globe Investor search for mutual funds and segregated funds with 10 year annualized returns less than 0% (after MERs, since all posted returns are net of MERs) yielded 592 results with data ending November 30, 2011. Here are a handful with links to their fund profiles on the Globe Investor site:
- Manulife Global Advantage: -10.10% 10 year avg, MER 3.07%
- Renaissance US Equity Growth: -6.67% 10 year avg, MER 2.73%
- Investors Global Sci & Tech-C: -6.66% 10 year avg, MER 2.92%
- TD International Value-I: -6.13% 10 year avg, MER 2.55%
- Russell Global Equity: -2.51% 10 year avg, MER 2.79%
Financial Advisor: I will give you an example (though I don’t have any client money in the fund)
Bissett Canadian Balanced Fund MER = 2.47%
These rates of return are calculated AFTER the MER has been deducted.
According to the calculations in your article, an investor investing $1,000.00 on Jan. 1 2001 would have only $759.49 left on Dec. 31 2010.
Preet: You’ve misunderstood. To calculate how much of your portfolio MERs will have consumed over time, the formula provided was 1 – e^(-25*m) for a 25 year period. To figure out the consumption over 10 years, we change the formula to 1 – e^(-10*m). For the above fund, this would be 21.89%. The annualized rate of return has no impact on this siphoning effect of fees. Had the fund had a 10 year annualized return of -2.5%, the effect of fees would still have consumed 21.89% of the portfolio’s potential value. Similarly if the fund had a 10 year annualized return of +25%, the effect of fees would still have consumed 21.89% of the portfolio’s potential value had there been no deduction of MER.
FINANCIAL ADVISOR: According to my calculations, the investor would have had $1,467.00 for a total return of 46,7%.
PREET: No debate here. If you started with $1,000 on January 1st, 2001 and added 3.80% in year 1, lost 3.40% in year 2, added 9.50% in year 3 and so on, you would indeed end up with $1,467. Perhaps this is where it will become clear as to what I’ve been talking about. Had there been no MER (no annual deduction of 2.47%), then instead of adding 3.80% in year 1, you would add 6.27% (3.80% + 2.47%) and so on. The series of returns would be individually increased by 2.47% and the cumulative return would increase from 46.7% to 85.8% for an ending value of $1,858. This represents a difference of $391 on a total possible $1,858, which is 21.04%.
You’ll note that we calculated this above as 21.89% using the formula 1 – e^(-10*m). The difference between 21.89% and the 21.04% calculated in the paragraph above is because the formula assumes continuous (daily) compounding (like in the real world) and the latter figure was calculated using the less accurate removal the of negative effect of the MER compounded on an annual basis.
Michael Wiener explains: “Here’s the gory detail on the reason for the difference. Adding percentages is just an approximation. In reality, the effect of the MER is to multiple portfolio value by e^(-0.0247) = 0.9756 each year. So, in year 1, instead of a return of 3.8%, without MERs, the investor would have had 1.038/0.9756 – 1 = 6.396% as a return. Note that this is slightly above the estimate of 6.27%. If you work out each yearly return this way, you’d get the correct figure in the end.”
To leave no stone unturned, here’s how $1,000 would’ve grown with and without the annual MER in chart form:
FINANCIAL ADVISOR: I looked at the prospectus of 3 Mutual Fund Companies: Mackenzie, Dynamic and AGF. Nowhere could I find a section “Fees indirectly borne by the investor”.
PREET: Here they are.
I grabbed a simplified prospectus for each company and picked the first fund. Here are the screen shots of the section in question.
Mackenzie – see page 61.
Dynamic Funds – this is for their Marquis portfolios - see page 45.
AGF Funds – see page 44.
FINANCIAL ADVISOR: What I did find were sections, and tables, headed “Fees and Expenses Payable by the Funds“ Are these what you meant (sorry my computer has just decided to use French symbols – so no more question marks)
PREET: No those are not what I meant, but there is valuable information there as well.
FINANCIAL ADVISOR: There follows, in each prospectus, the comment “Alternatively, a fund may have to pay some of these fees and expenses directly which will therefore reduce the value of your investment in a fund.“ The only way this could lead to what you have propounded in your article is, as I have earlier stated, is if the rate of return in a fund was 0% each year AND THEN the management fees were deducted.
Please, some answers.
PREET: I believe you have misunderstood both the “simplified” prospectus and the column. If you have any counter points, or more questions, you have my email address. Thanks for contacting me.