Mutual funds are an incredibly popular investment vehicle for many beginners that want to get started with investing. They’re really easy get into, especially if you purchase one from your existing bank, which may not even require you to open a new account. With the help from a commission-based mutual fund salesperson (or “financial advisor”), a new investor is able to conveniently participate in the markets without needing to do the homework that comes with the selection of individual stocks.
There is a dark side to the mutual fund industry, though. The cost of owning a mutual fund over the long term is high — really high!
Sadly, the fees associated with actively managed mutual funds are presented in a manner such that they’re essentially incomprehensible to a beginner. Most new investors wouldn’t think too much of a 2.8% management expense ratio (MER). It seems like a low number and thus a seemingly low price to pay.
Actively managed mutual funds typically command the highest of fees (well north of 2%), which may seem worthwhile to new investors for the “expert” money managers that they believe they’re paying for. The fact of the matter is that most of these professional fund managers often fail to beat the market consistently; oftentimes, it’s not even clearly communicated to the investor that the obscene fees are charged whether or not the fund makes money in a given year. Even if the markets tanked, the high fees are simply added to the tab, like a sprinkle of salt into a wound.
Don’t get me wrong. There’s no problem with charging investors high fees for services provided, as long as the costs are effectively communicated to prospective investors in plain English. With excessive fine print and overwhelming terms, however, it’s hard for beginners to truly understand the true price of what they’re paying for active management of their investments.
I don’t know about you, but if the average investor were to understand the real long-term costs associated with a 2.8% MER, I think most new investors would opt to take their business elsewhere, whether it’s through the route of passive instruments like index funds and ETFs or through construction of a portfolio through the selection of individual stocks.
Moreover, new investors are also likely at the mercy of their “advisor,” who may be battling with a conflict-of-interest scenario if they have a commission-based compensation arrangement with their employer. They may claim a high MER of 2.8% is a low price to pay and do everything in their power to keep an investor within a fund, so they can collect their trailer fees, an annual service commission paid to a mutual fund salesperson if an investor is still participating in a fund.
Over 80% of Canadian fund assets are held within commission-based accounts, and with Canadian regulators poised to announce a potential ban on trailer fees this month, we could see the tanking of shares in pure asset management firms like IGM Financial Inc. (TSX:IGM) and CI Financial Corp. (TSX:CIX).
I’ve been incredibly bearish on the non-bank mutual fund industry for quite some time now, and think that a trailer fee ban announced by regulators will be enough to push both IGM and CI off a cliff. Both IGM and CI have attractive yields in the 5.6-5.8% range, but I wouldn’t advise biting on them if you’re an income investor, as the capital losses could very well exceed the yield within a few trading sessions.
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Fool contributor Joey Frenette has no position in any of the stocks mentioned.