Before you buy units in any mutual fund, it is important that you know exactly how much it is going to cost. All charges are, of course, listed in the simplified prospectus. That is one good reason to read this document very carefully. (A prospectus is the selling document legally required to be distributed to mutual fund investors. Chapter 19 highlights the important points.) If you are still not sure of the fees involved, don't panic. Either telephone or visit your mutual fund sales representative and get him or her to explain the fee structure. If this means the salesperson has to take extra time to go over the various fees involved, so be it. If you would feel more comfortable with a written, itemized list of all the fees pertaining to your choice of fund, based on the amount of money you are investing, ask for one. For example, if you are investing $5,000, what will be the exact dollar amount of your fees on an annual basis? Above all, don't feel pressured into signing on the dotted line. Take your time, go home, think it over. You should do this in any case.
All mutual funds charge a management fee. It doesn't matter if you buy from a bank, trust company, broker, or the mutual fund company's own salesforce, you will pay a management fee. It doesn't matter if it is a load or a no-load fund, you will still pay a management fee. These fees are usually given as a percentage of the fund's total assets and pay the administrative costs and the wages and bonuses of fund managers. Funds charge anywhere from less than 0.5% for some money-market funds to nearly 4% for certain international funds. Management fees are deducted before the quoted performance numbers are calculated. This means that if you are interested in a fund with an 11.4% annual rate of return, this fee has already been deducted. In other words, you won't get billed personally. It comes off the top. That's why many mutual fund unitholders are completely unaware that their fund charges this fee.
To give you some idea of the amount of money we are talking about, let's assume you bought units in a fund with total assets of $2 billion and a management fee of 2%. The management fee for that particular fund would be $40 million annually. Make no mistake, we are talking big money here. This is where mutual fund companies make their profits. Moreover, this amount is paid whether the fund performs well or not. You may have to postpone your trip to Florida because of poor returns but the fund manager won't! Management fees are non-negotiable. There is no bargaining. If they say 2%, that's exactly what they mean.
Management fees for load funds (funds that charge a fee at the time of either purchase or redemption) may vary according to which option you choose. For instance, in one company, the management fee is 2% if you opt for a front-end load, 2.25% for a back-end load, and 2.5% for their no-load option. Get the salesperson to calculate how much your original investment would be worth, assuming (say) a 10% annual rate of return, over different time frames such as five, ten, fifteen, or. even twenty years, using the different options. You will then be in a position to make a more knowledgeable decision.
For a more accurate measure of the up-front cost to the investor, check out the management expense ratio (MER). It sounds highly mathematical but it is quite simply the total of all other expenses charged to the fund, plus the management fee, expressed as a percentage of the fund's total assets. For example, if a fund with $1 billion of assets has total yearly expenses of $20 million, its MER is 2% ($20 million divided by $1 billion). This means that out of every $100 you have invested, $2 goes to management expenses.
To ensure that they get their market share of your investment dollars, many mutual fund companies also provide independent salespeople (like brokers) with promotional incentives such as all-expenses-paid trips to annual sales conferences in locales like San Diego, Las Vegas, and Florida. These incentives increase the MER and decrease returns to unitholders. Moreover, there could be an inherent conflict of interest for the sales representatives, as pointed out in the recent Ontario Securities Commission's report, "Regulatory Strategies for the Mid-'90s -- Recommendations for Regulating Investment Funds in Canada," prepared by Glorianne Stromberg. Acting on the recommendations contained in the Stromberg Report, the Investment Funds Institute of Canada (IFIC) has submitted a draft code of sales practices as the basis for "voluntary" compliance by institute members. The draft code recommends that these promotional incentives be prohibited. IFIC is the lobbying and educative association of the Canadian investment funds industry. Its membership is made up of mutual fund management companies, retail distributors (such as brokers and financial planners), and members of the legal, accounting, and other professions.
A trailer fee is the annual service commission paid by the mutual fund company to your sales representative. This fee is paid as long as you hold units in the fund. These fees generally range between 0.25% and 1% and are paid out of the fund's management expenses. There are two points you should consider here. First, a trailer fee is a service commission. This means your salesperson should be providing you with ongoing services such as answering questions about your account, tax information, the performance of your fund(s), and other related matters. As pointed out, however, in the Stromberg Report, "no one monitors whether in fact the services have been provided," and "these fees may also be a factor in a sales representative not recommending a change in the client's portfolio when it would be in the client's interests to make such change." The Stromberg Report has recommended that the mutual fund industry voluntarily end the payment of these fees.
Second, through the practice of graduated trailer fees -- commissions that may, for example, start at 0.25% but end up at 1% as the amount of clients' money builds up -- some sales representatives could be receiving tens of thousands of dollars each year. The IFIC Draft Code has recommended that these graduated trailer fee payments be prohibited, thus removing the incentive for sales representatives to funnel clients' money into a particular fund. It does not, however, ban trailer fees in their entirety as recommended in the Stromberg Report. This means that some fund companies might pay a flat rate of 0.25% while others might pay 0.5% or even 1%. Therefore, the inherent conflict of interest still exists. Is the sales representative recommending a particular fund because it is the best fund for you or because it pays a high trailer fee? Not all mutual fund companies pay trailer fees to sales representatives.
A front-end load is a sales charge paid by you at the time of purchase to your mutual fund salesperson. This sales commission can be as high as 9%, although most companies recommend a maximum of 5% or 6%. The amount is negotiable with your mutual fund representative. When you see the words "maximum" or "up to" next to fees, it means you can bargain. This sales charge is deducted from the amount you invest. If you have $5,000 to invest and, due to your great bargaining skills, end up paying a front-end load of 3%, the actual amount of money invested is $4,850 ($5,000 minus $150). If you cannot get the salesperson to negotiate the fee, shop around. The betting is you can find someone else who will -- especially if mutual fund sales are low.
A back-end load is the fee charged to investors when they redeem, or sell back, their units to the fund. This fee is usually staggered, with earlier redemptions paying a higher fee -- a policy designed to discourage early withdrawals. A typical range starts at 5% or 6% for redemptions during the first two years and decreases to 0% after seven to ten years. The redemption fee schedule given below is typical of many funds.
|During the 1st year||6.0%|
|During the 2nd year||5.5%|
|During the 3rd year||5.0%|
|During the 4th year||4.5%|
|During the 5th year||4.0%|
|During the 6th year||3.0%|
|During the 7th year||2.0%|
Suppose you opt for the back-end load. Unlike with the front-end load option, this way your entire $5,000 goes to work for you immediately. There is no deduction when you purchase. If, however, you decide to sell back your units after three years, you have to pay the 5% redemption fee at that time.
Let's say your fund has made some modest gains and your original investment of $5,000 is now worth $6,000. Some funds base the redemption fee on the original amount invested. In this case, if you decide to redeem after three years, you must pay $250 (5% of $5,000). So you receive $5,750 ($6,000 minus $250). Other funds base the charge on the market value of your units at the time of redemption. This means you pay $300 (5% of $6,000) and take home only $5,700. Obviously, in this case, the first way is a better deal. If, on the other hand, your investment has declined in value, the reverse is true.
Choosing the back-end load allows all of your investment dollars to go to work for you immediately. But because most back-end loads are usually fixed (some companies might negotiate), you should be committed for the longer term to avoid paying these fees.
Before purchasing a load fund with the back-end load option, you should also be aware that although you don't pay a fee directly to your sales representative at the time of purchase, the mutual fund company does. This, of course, increases its costs. As a result, you may be paying a higher MER. Over the longer term, this higher MER could eat into your returns more than a one-time front-end load. Another point to keep in mind is that if the fund does not perform as well as expected, due to a change in management or other circumstances, or if there are better opportunities elsewhere, you may be reluctant to switch because of the high penalty.
Some load companies offer a no-sales-commission option. Again, check the MER. It will probably be higher than either the front-end or back-end load MERs. Over the longer term, this could significantly decrease your returns.
Some funds charge an early-redemption fee if you sell back your units within ninety days of the initial purchase. This charge can range from a flat fee of $100 to up to 2% of the initial value of your holdings. This means if you have invested $9,000, you can end up paying a fee of $180. Other funds, although they quote a redemption fee in their prospectus, waive this charge. Again, call and ask and get it in writing before you buy.
These fees may apply if you buy a load fund and choose the back-end load option. Distribution fees are paid annually from your account to your salesperson, either by a deduction from any distributions or by redemption of some of your units. Distribution fees (usually between 0.25% and 0.5% or in dollar terms between $2.50 and $5.00 out of every $1,000 invested) are calculated on the net asset value of your holdings. These fees typically increase along with the value of your investment for a predetermined period (normally seven to nine years). Some funds, however, charge this fee for as long as you hold units in them! In other words, if you invest $10,000, and the distribution fee is the lower rate of 0.25%, you start with payments of $25 a year. If your $10,000 increases to $15,000, you will pay $37.50 annually. It might not seem like much in the beginning, but over the life of your investment these costs can mount up to several hundred dollars and significantly reduce the overall return on your investment.
Switching Fees. Most banks and trust companies, and some mutual fund companies, allow you to transfer from one fund to another within their family of funds -- for example, from XYZ's bond fund to XYZ's equity fund -- at no cost or for a small fee of around $10. Do not assume, however, that your chosen fund falls into this category. A few companies charge anywhere from 2% to a maximum of 9% of the amount being switched. This means if you transfer $8,000 from one fund to another, you can end up paying anywhere from $160 to $720. If you are switching because the fund is a poor performer, this additional cost will only make matters worse. You should also keep in mind that switching -- selling units in one fund and buying units in another -- may have tax implications if your investments are held outside of an RRSP.
Set-up and Closing Fees. Some companies charge a nominal fee (around $50) to open or close an account.
Handling Fees. If you purchase no-load funds through an independent source such as a broker, you may be charged a handling fee of around $50 on amounts under $100,000 and $100 for amounts over $100,000. Because you are purchasing a no-load fund, the salesperson should not charge you a sales commission. The handling charge compensates them for the time they spend with you filling in the necessary forms.
RRSP/RRIF Fees. An annual administration fee (between $25 and $75) and termination fee (typically around $15) may be charged. Also, switching fees of up to 2% of your holdings may apply with some funds. This may not seem like much, but if you have $60,000 and you want to re-invest in another fund, it can cost you up to $1,200. Keep this in mind if you are aggressively investing for your retirement. Moreover, if you are in the fortunate position of having $200,000 -- which is not unrealistic towards the end of any retirement savings plan -- a 2% switching fee will cost you $4,000. Not the kind of money you want to part with if it can be avoided.
If there is anything you do not fully understand about a fund's fees, call or visit your fund company's nearest office. This will also give you a good opportunity to get an idea of the type of service and attitude of the company. If you are not satisfied with the answers you receive or with the level of service, you may want to reconsider buying that particular fund. If you are buying from an independent sales representative, you also need to know if he or she is being paid a trailer fee. If so, make sure you receive ongoing service.
A Final Word The IFIC Draft Code has recommended that clear and complete disclosure of all compensation payable to distributors be provided in summary form on the inside front cover of a mutual fund's prospectus. Investors should be aware that the recommendations contained in the IFIC Draft Code are, for the moment, just that, and IFIC does not have the power to enforce them.
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