A recent research report prepared by three professors at York University has gotten a lot of attention in the financial industry. This report studied the structure of mutual fund compensation and its impact on the decision-making of financial advisors. As a result of the report, some industry experts have asked Canadian securities authorities to completely ban trailer commissions, like the U.K. and Australian authorities recently did. Let’s review this issue.
How do mutual fund companies make a profit?
Mutual fund companies collect fees from the funds they manage. For example, a $10 million fund that charges a typical 2% collects $200,000 per annum in monthly payments. Investors who hold units of the fund are the ones paying these charges, which gradually reduce the value of their mutual fund holdings month after month. The lower the mutual fund fees, the greater the amount kept by the investors.
What are the types of mutual fund fees available?
There are two broad types of payment structures: fees with an imbedded trailer commission to the advisors and those without them, which are called “F-class.” What’s important here is that F-class funds are always less expensive than funds with trailer commissions. However, F-Class mutual fund shares must be purchased through a fee-based financial advisor, who charges clients an additional amount as compensation for his or her advice.
What does the report say?
The authors analyzed the relationship between fund performance, the presence of trailer commissions and investor loyalty. They found that funds with high trailer commissions tend to exhibit very high customer loyalty, regardless of performance. In other words, the authors found statistical evidence that financial advisors tend to favour high-commission funds, even when they underperform.
Why ban trailer commissions?
We believe F-class funds are generally more advantageous than trailer-commission funds. Investors with F-class funds are paying their advisor directly. This removes any incentive for advisors to select funds based on what’s more profitable for them and their employer rather than pursue their clients’ best interest.
Investment firms are mostly for-profit businesses. Advisors that eschew payments from mutual fund companies and require that clients compensate them directly are positioned to increase their profits by maximizing their clients’ returns. Higher returns will increase the assets under management, which will in turn generate more revenues for these advisors. Investing in commission-free mutual funds and ETFs, and charging management fees directly to the clients reduces conflicts of interest. This was one of PWL’s founding principles 20 years ago, and still today, the vast majority of PWL’s client assets are free of trailer commissions. The only exception is when such funds are more profitable for the client. This means that, ultimately, if the regulatory authorities decide to ban trailer commissions on mutual funds, things won’t change very much at PWL.