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

Posted by Preet on Mar 23, 2010 | 3 comments

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.

Mutual Funds: Great for portfolios up to $100,000

Posted by Preet on Jul 28, 2007 | 0 comments

I suppose many financial advisors licensed to sell ONLY mutual funds will cringe at this information. First, I want to say that if you have more than $100,000 in your portfolio it does not automatically mean that it is time to get out of mutual funds. But certainly once you pass this threshold you will want to look at alternatives to mutual funds as your options open up (based primarily on the fact that buying in bulk reduces your trading costs). If you remember in my first post on Mutual Funds we defined mutual funds as being the ideal investment for SMALL investors because trying to build your own diversified portfolio would cost too much in trading commissions.

So once you have built your portfolio past $100,000 it is time to compare costs of paying a mutual fund manager versus the costs of having a stockbroker build a custom portfolio (or yourself with a discount brokerage trading account if you have the knowledge).

Let’s look at the average Equity Mutual Fund. It has an MER (Management Expense Ratio) of approximately 2.6%. That means that for every $100,000 in your portfolio, you are paying $2,600 per year for management. When you were starting out your savings, perhaps you had $5,000 in the fund at the end of your first year – you were only paying $130 in fees. In fact, that is quite a bargain considering your advisor probably spent much time meeting with you, learning about your situation and creating a plan and investment recommendations. He or she does this so that when you become a larger investor, you become a larger source of income for the advisor. Also, by having built a relationship over time, it becomes a strong bond and there is less likely a chance that another advisor will lure you away (all thing being equal).

But let’s say you stay in this fund and now your portfolio has reached $1 million. You still pay 2.6%, and in this case you are now paying $26,000 in fees for the same management. It starts to get depressing if you consider that $26,000 every year could buy a new mid-size family car!

So let’s look at two options:

1. Fee based advisor

A fee-based advisor works on a set percentage of assets – think of it as similar to an MER, except that in the industry it is called a “Client Advisory Fee”. You don’t pay a trading commission for each stock purchase setting up the portfolio and similarly you can sell those stocks and buy new ones without incurring a separate commission. The Client Advisory Fee pays for all your trading costs, account admin fees, everything. Even if the Client Advisory Fee was the same as the MER (2.6%), it is advantageous because this fee can be written off for tax purposes whereas an MER cannot (for non-registered investment accounts only, you cannot write off fees for an RRSP). For easy math’s sake, let’s assume that our client is in a 50% Marginal Tax Rate. If they could write off the 2.6% Client Advisory Fee, then it effectively becomes reduced to 1.3%. That is a huge saving right off the bat.

But, it only gets better. While Client Advisory Fees usually can only be offered for $100,000+ sized accounts, this fee can be reduced automatically as the portfolio grows even larger. For example, the fee might be 2.5% up to $249,999 but once you reach $250,000 the fee might drop to 2.25% (and that would apply to the whole account, not just the funds over the threshold). Every advisor and firm have their own set of thresholds and fees – but know that you can negotiate the fee. As accounts grow to $1 million you should easily be able to negotiate the fee down to 1.25% (which, for a non-registered account could be written off and effectively reduce the fee to 0.625%) . When you set up your fee-based account, you will sign a document that clearly outlines the thresholds and fees for each level.

2. Transactional Advisor

In this case you pay a commission for each transaction – i.e. to buy or sell an individual stock. While it would take you maybe 20 purchases to setup the portfolio initially, and just for argument’s sake let’s say each transaction cost you 3% of the purchase price, then your first year would cost you roughly 3% in fees. BUT, once you’ve setup the portfolio most of the work is done, and the rest is maintenance. For example, you made 20 transactions in the first year, but in the second year you only made 6 transactions because it was time to sell 3 stocks, and you needed the other transactions to buy replacement stocks. So perhaps in the second year your total fees were only 0.9%. It all depends on how many trades you make in the year. (If you are an active trader, endlessly trading stocks then you already know you should be on a discount trading platform designed for active traders. )

It is important to note that you can replicate the characteristics of the mutual fund you’ve left with individual securities. But it might be more important to note that you can modify it now according to your personal preferences as well as paying a lower amount of fees every year.

I recently moved a client from another institution to my care. He had a portfolio of $180,000 entirely in mutual funds with an MER of 3.03%. We setup a fee-based account with a client advisory fee of 1.5% up to $1 million, and it would reduce to 1.25% over $1 million when he gets there. It was a non-registered account so he can also write off the Client Advisory Fee. Let’s do the math:

Before:

$180,000 x 3.03% MER = $5,454 yearly cost

After:

$180,000 x 1.50% Client Advisory Fee x 50% Write off of fee = $1,350 yearly cost

This client will save roughly $60,000 in fees over a ten year period. This will be due to the fact that the portfolio will appreciate over time and the yearly savings will also increase.

This is another “no-brainer” investment decision quite frankly. If you have over $100,000 in your investment portfolio, it’s time to speak to your advisor about fees. They would rather lower their income and keep you as a client then lose you and get NO income… And of course if your advisor can only sell mutual funds, it may be time to look for a full service broker who is authorized to sell everything (mutual funds, stocks, bonds, etc.).