As a boy growing up on a farm in rural Saskatchewan, a lot of sales representatives would show up at our door selling everything from life insurance and vacuum cleaners to encyclopedias. No matter who showed up, these sales reps had a certain determination to make the sale whether it was a correct fit for our family or not. The sales representative’s livelihood most often depended on making the sale. The first casualty of salesmanship is, almost always, the truth. In the interest of truth and transparency we offer you this series designed to clarify some common misconceptions about the investment industry.
Many investors are not aware of the layered or hidden fees in specific investments. So today, we will talk about the price it costs you to invest in some of the products.
Guaranteed Investment Certificates
On the surface you do not see any cost but banks and credit unions make money two ways from GICs.
1. They take a spread. What this means is they pay you a rate that is below what they could pay you. This difference in amount is their spread, or profit. An example might be you buy a 3-year GIC with a 2% rate of return. Hypothetically, the bank may have had a 2.5% spread meaning they paid you 2% and kept 0.5% for their profit.
2. The bank then matches your GIC to a mortgage and they lend your money out at a greater rate. If we use that same 3-year GIC where they are paying you 2% they might charge 3% for a 3-year mortgage. This way they make an additional 1% profit. Thus, in this example, you have the bank or credit union profiting 1.5%. No wonder Canadian Bank shares can be good investments.
Mutual funds are pretty simple for us to understand but if proper disclosure is not made to clients it can be very complicated. Mutual funds have two types of fees.
1. Sales fees.
A sales fee is a fee that a mutual sales person “can” charge.
- Deferred Sales Charge or DSC is the big one that today, while rarely used and even banned by some investment firms, still exists. Here, the company pays the sales person approximately 5% on the amount of purchase. Thus, if you invest $1,000,000 the advisor gets a cheque for $50,000 which must be disclosed to you at the time of sale. You don’t see any cost to your investment except you are locked into the mutual fund for roughly 7 years. To get out will cost you a fee.
- Low Load or LL is really another version of DSC except the sales person usually only gets 2% or 3% from their company and you are usually only locked in for 3 years.
- Front End or FE, tends to be the most popular way and is usually done on a No Load basis. The sales representative can charge up to 2% but usually charges nothing.
- F Class is applied if you are in a fee for service-managed account. The fund you buy would be an F class fund and there is no cost to buy or sell.
2. Management fees.
Fund expenses include management fees and operating fees. In some cases, investors are not fully aware of the difference between management fees and the management expense ratio (MER). As Investopedia notes, “the management fee is often used as the key determinant when making an investment decision, but the MER is an even broader measure of how expensive the fund is to the investor”. (Read more on the distinction here.)
MERs can run anywhere from 1.5% to 3% depending on what you are buying. These fees are embedded in the return of the fund. For example, if a mutual fund with a 2.5% MER reported a 1 year return of 8% it actually made 10.5% but kept 2.5% for itself and the mutual fund salesperson.
- On DSC, LL or FE funds, the mutual fund sales representative receives a trailer fee every year, which you pay through the management fee. The trailer fee ranges from 0.5% to 1.0%.On F Class, the MER is embedded but is always lower (usually by 1%) as there is no fee to any sales representative.
- Given this insight into fees, you can feel more informed when presented with a mutual fund recommendation from your advisor.
Knowledge is power: Look out for our next issue covering hidden and embedded fees
At Cooper Schneider Financial, we believe it is important for all our clients to be informed and educated about the specifics of what they are buying and why they are buying it. Our next bulletin will speak to common investment portfolio fees and explain the pros and cons of those portfolios as well as the variance in fees.
If you missed any of the earlier issues in this series, just give us a call or email us and we will send them to you.