Management Fees – Are you paying for Bondage or Advice?

by JamieList on July 15, 2010

Each year, Canadians decide how and where they will invest.  Other than asset allocation, the fees that are paid will likely have the largest impact on their account.  For some, fees will be paid to an advisor involved at some point in the process.  That advisor might be a planner or a broker who takes commissions or trailer fees as a result of managing a clients’ account.  Or, fees may be paid to an investment manager, either indirectly through ownership in mutual fund, or directly as a result of a discretionary or segregated account with that manager.

Outside of fees, you may also want to explore whether or not your advisor has a fiduciary duty to you, and if there are any conflicts of interest in your relationship.  Conflicts can arise as a result of the business structure (i.e. only recommending products from that company), but can also also arise out of compensation structures.

Essentially, the amount and type of fees you pay are what determines the kind of practice your investment advisor runs.  Instead of just asking “how much” the fees are, perhaps examine the types of fees you are paying, why you are paying those fees, and what incentive it gives to the recipient of those fees.

Trading Commissions

By far, the most common method of compensating advisors is still commissions.  However, all commissions are not created equal.  There are basically three types of commissions:

  • Brokerage commissions: when trading securities, a fee is charged based on the size and type of trade.  Some brokers will pre-arrange a fee schedule for their clients that provide a certain number of transactions for a fixed cost.
  • “Spreads” on Bonds:  Many investors are unaware that there is a commission paid on a bond.  That commission is called the spread, and it is the difference between the actual rate being paid on a bond, and the rate at which it is sold to you.  For most bonds the spread is between 10 and 25 basis points (0.10% and 0.25%).
  • Mutual Fund “Front End” commissions: when an advisor recommends a fund, the client is charged a percentage of their investment in order to purchase units in the fund recommended.

In all cases, the commission here is a fee paid as a result of a transaction.  Make sure that, when you are working with an advisor, you are comfortable with what those commissions mean.  The commission regimes mean that the advisor gets paid when you act on their advice.  Thus, it is reasonable to say that their bias will be to implement a portfolio solution that prefers action.  If you are an active investor, then this will compensate an advisor who continues to bring quality investment ideas to you.  However, if you are an inactive or conservative investor, you may feel that you are pressured to take action that you do not feel is in line with the objectives of your portfolio.

Deferred Sales Charges

Mutual Fund “Back-end” commissions are a contentious topic among investment professionals and the investment public.  These “deferred sales charge” occur when a client purchases a new fund within a mutual fund company.  The advisor is paid a commission by the fund company, but the client is required to remain with that fund family for a certain period of time to account for those fees being paid, usually 3 of 6 years.  After the first year, those funds pay a trailing commission to the advisor of roughly 25 to 50 basis points.

The upside is that there is no immediate cost to the client.  In addition, the commissions paid are usually either 2.5% or 5.0%, and this allows advisors to receive compensation from smaller accounts, and enables them to spend the appropriate time with those smaller clients to deliver proper advice.

The downside, however, is that the bias for a practice run with this compensation scheme means that the advisor is paid to meet and satisfy new clients rather than existing clients.  If an advisor is being paid 5% on a new client and 0.50% on their existing clients, the attention of their practice is likely biased towards the initial portfolio set-up, and not necessarily the ongoing management of your account.  If your advisor recommends the use of these charges, ensure that you are comfortable that you will continue to receive the same quality of advice into the future.  In addition, your advisor should not be asking you to re-invest in deferred sales charges again once the deferred sales charge period is over.

No Load

No load compensation schedules are generally by advisors working with mutual funds, and are intended to mimic the type of compensation schedule that investment managers receive (see below).  The no load schedule means that the advisor receives their compensation as a percentage of the assets they have under management.  This means that their bias is towards maintaining the assets they already have, as there is no extra incentive for them to attract new clients, and there is nothing stopping them from leaving if they are unhappy with their service.  These are a form of servicing commissions, as above, but are the only form of fees these advisors receive for clients invested in these funds.  Thus, their bias will be towards more inactive clients.

Servicing Commissions

Servicing commissions are fees that are paid by fund companies (generally) to advisors for maintaining the accounts that they have.  Servicing commissions vary depending on whether the advisor has recommended a front end load, no-load, or deferred sales charge fee options for their clients.  Reasonably, these are the fees that the advisor receives for maintaining your account over the long term.

Investment Counsel Fees

A direct relationship to a discretionary portfolio manager usually means a fee schedule much like the “no-load” schedule described above.  These fees are usually lower, as a result of the size and structure of accounts being managed.  In addition, it is generally accepted that these fees are tax deductible for non-registered accounts (although taxpayers are advised to consult their tax professional to ensure this is the case for them).  The fees paid to these managers can also be mixed with an incentive fee of some sort, such as a share in a percentage of profits.  This is more commonly found in managers with higher risk or specialty mandates.  There are a variety of “retail” solutions like this that are available to clients through advisors that mimic this relationship.  Two of note are offered by SEI and Franklin Templeton.

Your Objectives

Perhaps the best advice ever spoken on this topic was delivered by Upton Sinclair when he uttered the following: “It is difficult to get a man to understand something when his job depends on not understanding it.”  More specifically, if your objectives do not fall in line with the method in which your advisor receives fees, it will be difficult for you both to see eye to eye on an investment strategy.  While the fee discussion tends to raise the blood pressure of both clients and advisors alike (for different reasons), it is a discussion that should be had.

Regardless of the fee schedule, good quality advisors are likely going to give good quality advice to their clients, regardless of the fee schedule.   However, even good quality advisors are running a business, and the business decisions that they have made about their practice are going to impact how they deliver their advice in the future.

As far as I can tell, there has already been much written about fees, and a recent report suggests that Canada’s mutual fund industry may have the highest fees in the world, on average.  So what is an investor to do when faced with the costs of investing?

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{ 1 comment… read it below or add one }

Richard Carmichael July 22, 2010 at 2:34 pm

Very informative post. Thank you for this. Just like anything else, we hope that we get what we pay for. What is the best way to protect yourself from paying too much?

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