Growing Active ETF Market Means Mutual Funds Should Consider Allowing F-Class Units For Sale Through Discount Brokerages

This past Monday I had a guest post about how Actively Managed ETFs will signal a threat to the staying power of mutual funds as portfolio stalwarts. In the face of mountains of evidence supporting indexation strategies, actively managed mutual funds with embedded financial advisor compensation have flourished. The author essentially argues that the mutual fund structure is being challenged as now investors can access active managers while bypassing the financial advisor as an intermediary. For more, please make sure to read the guest post here.

Today’s post title would be the logical reaction to the “threat” of actively managed ETFs. By allowing the widespread sale of F-class units of mutual funds through discount brokerage accounts the fund industry could help stem any potential losses.

F-Class Mutual Fund Units

For those not familiar with F-class mutual fund units, they were developed for Fee-based accounts where advisors would charge a transparent fee which was not embedded in the fund’s MER.

For example, let’s say that Mutual Fund ABC had A class units with a 2.50% MER, of which 1.00% went to the advisor annually as their compensation. The investor would not explicitly see the portion of the fee going to the advisor (1.00%), nor would they see the 1.50% going to the fund company for the portfolio management, reporting, etc. If the return for the year was 10.00%, the portfolio’s actual return would’ve been 12.50%, but the 2.50% would reduce that to the 10% the investor sees.

Now, that same mutual fund could be offered in a F class unit (same portfolio) which has an MER of 1.50%. The advisor might charge a “client advisory fee” of 1.00%. The total cost is still 2.50% but in this case the 12.50% portfolio return is only reduced by 1.50% so the investor sees a portfolio return of 11.00% BUT they also see 1.00% in fees deducted explicitly on their statement which goes to the advisor, leaving them with the same 10.00% net portfolio return.

It should be pointed out that the 1.00% client advisory fee is potentially tax deductible for non-registered accounts, which would leave the investor slightly ahead versus the A class units with the same overall fees.

So what’s the big deal? Well, for one that Client Advisory Fee is negotiable, but that’s beside the point. Right now, you can buy A-class units of actively managed mutual funds through a discount brokerage and bypass the use of an advisor, but you still pay the 1.00% that would go to an advisor. Essentially, you are paying more than you have to. Many fund companies have blocked the sale of F-class units through discount brokerage accounts in order to appease financial advisors who would be threatened by this practice. Presumably, when bought through a discount brokerage account, an F-class unit would be absent any advisor compensation and in our sample mutual fund, the investor would pay an MER of 1.50% versus 2.50%. (These MERs are just examples, they could be higher or lower.)

Hop On or Get Out Of The Way

So… if the proliferation of Actively Managed ETFs accelerates (which it has) then DIY investors will be more inclined to circumnavigate financial advisors in order to access active management without the advisor compensation drag on portfolio returns. If the fund companies are unwilling to realize that there will be an exodus then they stand to lose market share going forward.

Let me be clear with my own perspective: there is value in advice and I believe that most people will be better off with an advisor. But, the truth is that there is a significant portion of the investing public who wish to do it themselves and that demographic will increase.

Witness the FSA in the UK moving to ban commissions for financial advisors, and similar directives in Australia for CFPs. The advice delivery mechanism is changing to an unbundled structure (advice not tied to products), so making F-class units available through discount brokerages is only logical for fund companies from a business perspective.

It wouldn’t signal the end of financial advisors as some might fear. I believe there is an equilibrium (like with pretty much everything) which would shift from 10% DIY / 90% Advice to perhaps 30% DIY / 70% Advice whether the fund companies do this or not. If they do it though, they should be better off.

Comments welcome.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 5 comments
  • Gail Bebee

    Preet, you are highlighting the dirty little secret of many discount brokerages: they are pocketing fees received from companies whose mutual funds are held by their clients, but not providing the advice these advisory fees are intended to pay for.
    You would be doing DIY investors a great service if you would publish a list of the fund companies, which do not pay these fees to advisors. This will help DIY investors make better informed decisions about what they are paying for when they buy mutual funds.

  • Investor

    Brilliant! You are absolutely right with this analysis. I think it will come down to politic-ing at first, but if other star managers like the guys at Front Street start trading portfolios for ETF makers then it is only a matter of time. Bravo to that, and to you Preet. You must be way older than you look.

  • Brian Poncelet, CFP

    Gail,

    You have made a good point here. Another point not really talked about is risk management and taxes. Since taxes eat away any gains on fees saved. Since we work about six months a year to pay different levels of taxes…income taxes, HST, property taxes, user fees etc. Doing taxes myself, I see too much money going out the door every year unknowingly transferred away to CRA.

    Currently, the discount brokers don’t do income taxes or corporate taxes or talk about risk management. You have to build a house with at least a floor.

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