Sales commissions are another topic about which misconceptions abound. Here are some very common misconceptions, together with what we think are real life answers to some frequently asked questions:
Load or no-load?. The first, and most common, misconception is that no-load funds are better than load funds. But if you receive, and are willing to pay for, investment advice, it's not necesarily true. In fact, we are talking about two different advisor compensation structures: each may better fit different types of investors than others.
Advisor fees are generally paid in one of two forms: a) in the form of trailer fees, which are included in your fund’s MER (deducted from your mutual fund returns by the fund company and paid directly to the advisor) or, b) directly by the investor to the advisor. Somehow, the market takes care of things such that you end up, in most cases, paying a similar overall cost.
Generally speaking, no-load funds pay minimal or no trailer fees, which explains why such funds invariably have lower management expense ratios. So if you are a do-it-yourself investor who does not need investment advice, you can save fees by selecting no-load funds. But as the table below shows, once you have agreed to pay for advisor services, chances are you are not better or worse off with any particular type of advisor. The table below shows how two investors, with $50,000 to invest, would typically end up paying the same fees.
|Total Fund expenses||$1,375||$875|
|Independent advisor fees||N/A||$500(2)|
|Total Price of advice(3)||$1,375||$1,375|
Note 1: assumes a 1% trailer fee. Some funds (particularly fixed-income funds) may pay a lower trailer fee. Trailer fees can be negotiable depending on amount invested and complexity of services required or provided.
Note 2: assumes advisor fees of 1%. Some fee-based advisors may charge more or less, depending on the amount and complexity of services required or provided.
Note 3: For mutual fund advisors, price of advice (POA) refers to the fund’s management fee (in return for money management services provided by the fund manager) in addition to fees paid to the financial advisor (whether directly by the investor or in the form of trailer fees).
Do commission-based advisors have a conflict of interest?
Every profession has its own version of moral hazard, and advisors are no different from any other professionals. If you trust your advisor to work consciensciously for you, you need not worry. If you don't trust or don't feel comfortable with him or her, you should change your advisor the same way you change your doctor, lawyer or accountant.
For starters, keep in mind that most advisors have a certain limitation as to what funds they can recommend. While commission-based advisors are generally restrained to load funds, fee-based advisors typically go for either no-loads funds or “F” class funds (F class funds are a special version of load funds that pay no advisor fees). While nothing would theoretically prevent a fee-based advisor from recommending a load fund that he or she may like (which the client would buy through a discount broker), such decision would put the client at a cost disadvantage: over and above direct advisor fees, the client would be paying a high MER that includes a trailer fee to the discount broker.
Having said that, this does not make any particular type of advisors better or more suitable than the other. Each type has a huge variety of good funds from which to choose. In addition, advisors know that their annual remuneration will ultimately depend on how your investments do. For them, recommending good funds is the win-win solution.
Which is better, front load or back load?
The answer is simple: there is no better or worse, each option has its advantages and disadvantages. Front-end load, also referred to as the Sales Charge alternative (SC), consists of a direct commission charged to the client upon purchase of the fund. This commission, in theory, could go up to 9%. But in practice, it varies usually between 3% and 5%. The trailer fee on SC funds is usually 1%.
Back-end load, also referred to as Deferred Sales Charge (DSC), consists of a direct commission paid upfront by the fund company to the advisor (i.e. the client pays nothing upfront). For as long as the investor keeps the fund, the advisor typically receives an additional trailer fee of 0.5% each year. If the investor keeps the fund for a certain period (typically 5 to 7 years) he or she would pay no commission. However, if he or she sells the fund before that period, a redemption fee is levied.
For investors, the advantage of DSC funds is that, by holding the fund for the long term, they would avoid sales commissions altogether. On the other hand, if for whatever reason they decide to redeem the fund before the time, redemption fees could be punitive. Having said that, with good, large fund families, there is such a wide variety of good funds to choose from that investors have the flexibility to switch funds, within the same family, without incurring redemption fees. Generally speaking, if you're in for the long-term, you need not worry too much about redemption fees with any family that has a broad choice of well performing funds.