Ken Kivenko’s column is all about investor protection. Ken fights for investors’ rights and exposes violations and malpractices. He also runs an advisory business, FundBuster Analytics, assisting investors obtain restitution due to sales or broker abuses.
Trailer Fees: A Vitamin or Toxin?
By Ken Kivenko | Thursday, September 29, 2005
Our investor advocate explains all about trailer comissions
Trailer fees, sometimes called service fees/commissions are “fees” the mutual fund manager claims to pay to the individual and/or organization that sold the fund for providing ongoing services such as investment advice, performance statements and tax guidance to investors. Industry critics label these trailers as commissions to better reflect their actual application--to keep you invested in the mutual fund. In the view of many it’s just another example of a sales-based industry trying to borrow the credibility of professionalism by using their lingo (e.g. “fees”). Investor advocate Joe Killoran has labeled trailers as “tied advice / tied sale” under his disclosure thesis and provides a suite of checklists to aid in adviser-client communications on his website
http://www.investorism.com. The OSC’s Fair Dealing Model had three core principles that attempted to address the asymmetric information issue:
There must be a clear, documented allocation of roles and responsibilities among the investor, the adviser and the firm.
All dealings with the investor must be transparent including fees. Transparency is disclosure that is understandable and meaningful to an investor and communicated at the time and in the manner most useful to the investor.
Any conflicts-of-interest the adviser has must be appropriately disclosed and managed to avoid self-serving outcomes.
Regrettably, the FDM seems to have fallen into a CSA swamp
Prospectuses generally refer to this ongoing charge as trailing commissions and do not identify precisely the charges related to a particular fund but use vague terms such as “up to” or “may pay”. Lawyers have worked their magic here for sure. Trailer fees are opaque to say the least. You can get a sense of the magnitude by reading a fund’s Simplified Prospectus, available on-line from your adviser, the fund company or via
http://www.sedar.com. Trailer commissions are not an item on fund client statements showing the cost in dollars and cents of the “advice” supposedly provided. Strangely, regulators have not required prominent plain language disclosure at the point of sale or even standard terminology but truly professional advisers are making use of Engagement Letters and Investment Policy Statements to make the costs of advisory services more transparent.
Proponents of trailer commissions argue that the ongoing services are valuable benefits to investors and salespeople must be compensated for their work. For anyone who’s received a crummy client statement and tried to make sense of it, the words ring hollow. Many fund salespersons are not even qualified to provide tax advice. Wisely, most don’t even try to provide it.
Trailer fees are usually in the range of 0.25 % to 0.50 % per annum for DSC sold funds but can exceed 1 %. Equity funds sold with a front-end load typically pay advisors 1% annually. Proprietary funds may offer the highest trailers but are often the highest cost for investors. All the money comes out of the manager’s management fee. Most Index ETF MERs are less than this, e.g. the i60 MER is just 0.17 %. Trailers vary from Company to Company, fund category and load classification with money market funds paying the least. Typically, financial advisors obtain 50% of the annual trailer fee commission when their sales transaction is DSC or Front-end load (high load); they receive 100% of the annual trailer fee commission when their sales transaction is ZERO load, No-Load or Low-load (2% or less). When a DSC fund “matures” advisors often want to convert the position to front-end load on the basis that it makes no difference to the client. In reality the trailer typically doubles from 50 to 100 bp. The extra 50 bp was originally used to “amortize” the advisor’s DSC sales commission. Once that’s paid off, there is no longer any justification for the fund company to charge it. It should be rebated back to the client -- it’s their money after all -- not paid as a bonus to the advisor. Indeed, the fund should automatically convert to a front-end load where the MER should be, but isn’t lower.
The management fee, which includes the embedded trailer, is extracted from the fund’s assets so it’s the investor that’s paying the bill, albeit obliquely. On a $ 300,000 mutual fund account that’s typically about $1,500 p.a. for every year you hold the fund, escalated by any growth in the account. Over an extended time, the decompounding effect of trailer commissions can be hazardous to your financial health if you’re not getting the appropriate advice.
Trailer commissions paid are not an isolable item you’ll find articulated on fund client statements or fund Annual Reports. As with so many other fees and expenses, trailers are subtracted from a fund’s assets so all investors get to see is the Net Asset Value upon which return calculations are made. Critics believe there is a heavy bias towards putting investors into higher risk equity funds where trailer commissions are often highest. It’s also strange that advisers rarely recommend stripped coupon bonds or straight bonds where there are no trailers instead of bond funds with lucrative trailers. Authors John DeGoey (the Professional Adviser) and John Reynolds (the Naked Investor) have documented cases illustrating the process .A Small Investor Protection article located at
http://www.sipa.to/investorsCorner/cornerMain.htm warns:
“… Since the sellers are generally commission-driven and some managers push the salespeople to generate more commission there is a natural impulsion to employ strategies that maximize commissions. This can result in churning of accounts, or excessive trading. The mutual fund sellers will often employ the tactic of selling 10% of your mutual funds each year and then reinvesting in other funds to generate new commissions which are greater than the trailer fees they would receive if you held your funds…”
Even David Brown, former OSC Chair, told a May Toronto CFA Society meeting expressed his concerns about embedded commissions in the context of the Portus hedge fund scandal. He said that:
"When considering the extent of the distribution of these products, it is important to keep in mind that this was not a case of early investment successes fueling explosive demand. And the promoter was a relatively unknown individual, with no proven track record and no market reputation. So what could have accounted for the firm’s tremendous sales record? Perhaps there is only one particular feature to speak of – high up front fees and trailer fees for referrals. The potential earnings for agents were high....
Cynical critics also believe that trailers produce a powerful conflict-of-interest for the salespeople who could encourage investors to stay in the fund even when market conditions might indicate that they should redeem their units and keep the money in cash, GIC’s or bonds. Since advice should also include when to SELL as well as when and what to buy, you’d think this actually happens. With few exceptions, don’t count on it unless it’s to churn the account into another fund which may result in a renewed sales commission and continuing flow of trailer dollars to the adviser. In most cases, the sale has nothing to do with market conditions, a change in objectives or suitability.
Critics of the ongoing trailer commissions also argue that investors who hold funds for the long-term end up paying higher overall fees than they would if they had paid a onetime front or back end load. The most outspoken of the critics label the trailer fee as a poorly disclosed inducement or more politely as a “facilitating payment”. Also, trailer commissions are paid from fund assets to whoever sells a mutual fund-even an on-line discount broker, who isn’t even allowed to provide advice. This is controversial because on-line brokers provide no on-going service, other than statements and record keeping. Some exchange traded funds also pay trailers with the same degree of illogic .The only possible reason the payments are made are to keep you invested in the fund so that the fund Company can continue to earn fees each year off your investment.
In too few cases is the existence of trailers highlighted to investors by their advisers. A 2002 paper Out of Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=496315] by Brad Barber, Terrance Odean and Lu Zheng concluded that:
“..We report evidence that mutual fund marketing does work. On average, any negative effect of expense fees on fund flows is more than offset when that money is spent on marketing; non-marketing expenses, however, reduce fund flows. Though load fees are also spent on marketing, the positive effect of marketing on flows does not appear to be sufficient to offset investors growing awareness of and aversion to loads…”
Fund companies usually watch every nickle they spend, but in the case of trailers they just send out the cheques without regard to the quality of service, frequency of service or even if the service is provided at all. There is rarely if ever, a follow up with investors to determine the level of satisfaction with the so-called trailer services provided. This fact alone suggests that trailers are seen as commissions by industry participants rather than a real advisory service for investors. Indeed, some theorize they are commissions to make up for the 8% front sales load charges that prevailed in the late eighties i.e. 5 % sales commission (paid out of the management fee of DSC funds) + 6 (could be 7) yrs DSC period x 0.5% = 8 % (or 8.5%). The numbers seem to validate the theory.
A wonderful article on how to avoid trailer commissions located at
http://www.asldirect.com/ASLDirect%5CAS ... ancialPost states:
“..Have you ever wondered where mutual fund salespeople invest their own money? Many believe in the products they sell but most are only too aware of the long-term impact of annual trailer fees of 0.5% to 1% on their performance. Some have the best of both worlds by putting their personal portfolios with ASLDirect.com, a firm created in 1999 by Mr. ASL himself: Adrian Samuel Leemhuis. ASL rebates trailer fees to customers. As noted the last time ASL was mentioned here -- two years ago -- the firm makes its money charging a flat $29.95/month subscription. That makes it cost effective for portfolios of $50,000 or more…”
Conclusion
Most investors don’t understand trailer commissions and the inherent conflicts-of-interest they cause. Many don’t know they exist despite the many articles that have been written on the topic. Now that you know they exist, ask your adviser to disclose them and make sure you get your money’s worth. Informed investors who do not need or want continuous service can choose mutual funds from firms that do not pay trailer fees. You can also consider low-cost, tax-efficient index ETFs. Low-cost F Class funds which have the commissions stripped out are unfortunately not available to investors without going through an adviser (an attempt by E*Trade Canada to make them available was quickly crushed by industry participants). If you do need financial advice, consider a fee-only account with a trusted, professionally qualified adviser. You’ll get personalized client statements that show personalized returns and an enumeration of fees so you can determine whether or not you are getting value for the fees. In most cases, you should be able to deduct the fees for income tax purposes
Ken Kivenko P.Eng., August 2005