One common complaint when it comes to mutual fund fees, is a general hatred for DSC (Deferred Sales Charge) load mutual funds. While I understand that nobody likes paying fees, I also think that this fund load is misunderstood and can be beneficial for smaller investors who invest through an advisor.
What are DSC fees and how do they work?
When you buy a DSC mutual fund from an advisor, you don’t pay any kind of direct sales fee. Instead the mutual fund company will pay the advisor an upfront sales fee – usually around 5%. This way all of your money gets invested and your advisor gets some payment.
The catch is that these funds have a DSC fee schedule which usually start at around 6% and last for approximately 6 years. The fee will decline each year until it gets to zero. The DSC fee is only applied to investors that sell their mutual fund units before the DSC schedule has finished.
Here is a sample DSC schedule:
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If you were to sell your mutual fund in year one, the DSC fee would be 6.0% of the investment amount. If you wait until year 4 to sell, the DSC fee would be 3.0% of the sale amount. Note, that some companies will calculate the fee on the original purchase amount.
The problem is that most people who buy DSC funds are not aware of how DSC fees work and consequently get upset if they sell their funds and get nailed with unexpected fees.
Why DSC fees are not as bad as you think (and ways to reduce the fees)
1) Advisors need to get paid
If you want to use a financial advisor then you have to pay them. It takes time for an advisor to meet with you, get an account set up and handle the paperwork and transactions. DSC load funds allow smaller investors to avoid paying direct fees and enable them to get all their money invested.
Trailer fees are not enough. Trailer fees are fees – usually 0.5% to 1.0% per year which are paid to the advisor from the mutual fund. These can be very lucrative for larger accounts, but for a small investor – they don’t add up to squat.
The alternative to DSC funds for a small investors is direct fees. For example, an advisor might charge $100 to set up an account.
2) DSC fees are not applied to switches between funds at the same fund company
If you own XYZ Growth Fund and you want to switch over to XYZ bond fund, then you should be able to make that switch without paying any DSC fees. The original DSC schedule should carry over to the new fund.
Of course this means you can’t leave that particular fund company without paying DSC fees, but you are not locked into any single fund.
3) DSC fees go down over time
If you wish to withdraw your money from a DSC fund, phone the fund company to find out how much the DSC charge will be. If you’ve had the account for a while, then you won’t be paying the maximum charge.
4) 10% free option
Most fund companies have an annual 10% free withdrawal for DSC funds. What this means is that you can take 10% of the fund value (as of the beginning of the year) and switch it to a non-DSC version of the fund. Or you can just redeem the 10% amount if you wish.
This is something that you have to request every year, but the more DSC load units you can switch to non-DSC load, the lower the DSC fee will be if you sell the fund.
5) Negotiate the DSC charge
While the basic DSC fee can’t be changed, you can sometimes negotiate with your advisor to reduce the amount of fee that the advisor keeps. Any difference will be deposited in your account as a new purchase.
For example if the DSC fee is 5% and your advisor agrees to reduce her commission to 3%, then the 2% difference will be placed in your account.
This leads to the interesting situation of a “cash-back” purchase where you end up with more money in the account than you deposited. In the example above, you would end up with 102% of your original purchase.
This is typically used when an investor is moving money from one fund company to another and is hit with DSC charges on the sell side, however it will work for any purchase.
The amount you have to invest will help determine your success with this strategy. The more money you have, the more leverage you have.
6) Timing of the sell
Check with your advisor or fund company to see if the DSC fee will drop significantly if you wait a bit. If you made a large purchase to open the account and you are close to a lower level in the fee scale, it might be worthwhile to wait.
Please note, that these rules are general. Phone your advisor or fund company to verify the exact fund company rules before doing anything.
Should I wait to convert my expensive funds to cheaper index funds?
No.
If you own an expensive mutual fund with a 2.50% annual MER and wish to switch to a cheaper fund which has a 0.5% annual MER, then you will save 2.0% per year. As long as you stay invested in the cheaper fund for at least a few years, then the annual savings will quickly outpace any DSC fee.
Should mutual fund DSC fees be banned?
The main problem with DSC fees is the lack of disclosure. Most financial advisors “sell” mutual funds and DSC fees are not a good sales pitch. A friend once told me that an advisor tried to get him to invest his house down payment savings in DSC equity mutual funds. That kind of advice is as bad as it gets.
If DSC load funds were banned, then it is likely that no money will be saved by investors. Here are some things which might happen – especially for smaller investors:
- Front load fees more likely to be charged. These are fees which will apply to the sale price and will come out of the investment amount.
- Direct fees more likely to be charged. Fees like account setup fees, transaction fees might be charged.
- Refusal of service. An advisor is not going to work for peanuts – if you are not a profitable client then they will likely refuse to work with you.
Summary
DSC fees are an indirect method for mutual fund clients to pay their advisors. Lack of DSC fee disclosure is bad, but DSC load funds are not.
More information
Larry MacDonald makes a good argument against DSC fees.
17 replies on “In Defense Of Mutual Fund DSC Fees For Smaller Investors”
Good post, Mike. I’m the last person to be an apologist for the advisory industry, but as you point out, if you want the services of an advisor, you have to expect to pay for it. And most consumers are unwilling to write a cheque to their advisor the way they would for a lawyer or accountant. Ask some fee-only advisors how hard it is to make people understand that advice costs money.
It’s also important to remember that before DSCs appeared, it was customary for mutual fund companies to charge 9% front-end loads! For long-term investors who genuinely need the services of an advisor, the DSC model is vastly superior to that, as long as it is fully explained.
Given that investors seem to believe that they don’t pay their advisors at all, my complaint about DSCs, front-end loads, and MERs is all the same: explain them to investors in a way they can understand them. The real measure of which type of fees are better comes down to how much money the investor pays.
My issue with DSCs is twofold.
The first is that you’re essentially locking yourself into a relationship for a number of years with someone that you can only do a limited amount of research on in the first place. So if they answer the questions well and seem to be a good sort the novice investor will sign on, and then if the relationship changes or sours it’s pretty darn difficult to get anything useful out of the situation for several years. (10% per year is still leaving half your money there for the full period and getting none of the advice you hoped for) At least a fee only advisor or a no-load scheme has no ties to break.
The other issue I personally have relates to human nature itself and the reward behavior promoted by DSCs. As mentioned, trailer fees are piddly amounts for small accounts – so the greatest reward for an advisor comes from the commission fees. For most people, it is only logical to devote the most effort to the pursuits that win them the most compensation. For an advisor in this scheme, the most optimal pursuit is to lock in as many clients as possible while letting existing clients slide. Sure – some advisors will realize that a stable of happy clients generates more long-term income than a constant rotation, but in the short term DSCs (and Front Loads too) reward salesmanship over service.
Being a former commission based advisor, I think advisors deserve to get paid. That being said, I’ve always preached that it’s about VALUE. Advisors need to justify their VALUE. What are they doing to deserve to get paid? Put financial plans together? meet with clients annually? Research? Good advisors know their value and are not afraid to disclose but also justify their compensation!
@CCP – Thanks. I had forgotten about monster front-end loads of the 80s. I’d rather pay a potential DSC fee over a certain 9% front free. Of course as a DIY investor I won’t have to make that choice.
@Michael – I agree that the total fees paid is the proper measure. One problem is that fees don’t help sell financial products, so advisors don’t like talking about them. The other problem is that if an investor thinks they are getting financial advice for free, they don’t want to know about the costs because they think it doesn’t concern them (even if it does).
@Jak – That’s not the way DSC funds work. If you buy DSC funds with one advisor, you can then get a new advisor and transfer over your existing funds to the new advisor. You are not locked into that advisor in any way.
As for your 2nd point – Yes, the financial advice industry in Canada (and elsewhere) is 100% driven by sales. That’s why investor education is so important.
@Wealth Wealth Guru – Great point Jim. It’s not just about the fees, but the service provided has to be considered as well.
Mike
Thanks for link! One thing that could perhaps be added is that DFCs are still fees embedded in the product. Advisors deserve to be paid of course, but this approach can lead to advisors recommending funds according to how much they pay out as opposed to whether or not they are actually good for the client. Second, there is a good argument for viewing DSCs and trailer fees as kickbacks to salespersons versus payment for services rendered (as a recent academic study argued). Specifically, many mutual-fund salespersons will feel a duty to provide service to their clients but others will neglect existing clients (especially the smaller ones) and be more focused on getting new sales (and meeting company quotas).
I think the biggest problem in Canada is that MER’s are too high, because mutual fund companies want to maximize the fees charged.
For example, American Funds, the largest load fund family in the US, have MER’s around 1.5% including the DSC fee (https://www.americanfunds.com/funds/returns/alphabetically.htm?fundClassName=B).
Mike, you probably want to do an article on “low load” funds. Advisors like to sell those as well. Different companies have different “low load” schedules. I read that Fidelity has 2% upfront commission paid by the fund company, .5% trailing commission, and the fund is locked for two years. I heard that AGF pays 2.5% upfront commission to the brokerage, .5% trailing commission, and the fund is locked for three years.
My biggest critique about DSC or Low Load Funds is that it is incompatible for people who are seeking the best portfolio managers in active managed funds. The best talents often switch companies after establishing their record. If the manager leaves, the person is stuck with the fund because of DSC or Low Load charges.
In economics, I was taught that transparency about price is very important in making good decisions. I find that DSC or Low Load Funds lack the transparency on the price that you are paying for the financial advise. If people think that are not paying for advise, then people will not demand advise from their financial advisors. Thus, financial advisors can get with receiving commissions and not providing advice.
I don’t think the problem is with A, B & C shares, but rather the lack of disclosure involved by a number of poor advisors.
Personal Finance Bloggers (not you Mike) are quick to state that fee based is the only way to go, but don’t really go into the obvious problem of how many people are actually willing to write the check.
@Evan – I couldn’t agree more. Lack of disclosure + shady practices by advisors is the real problem.
Fee-based can work, but only if you have enough assets. Investors who are just starting out should just spend their “fees” on a few good books!
Quick question, if you have been contributing monthly to a fund with deferred sales charges for, let’s say over 6 years in your example above, can I only withdraw the amount I’ve had invested over 6 years without paying any fees? Alternatively, I suppose one can use the 10% option if that amount is greater.
@Big E – Yes, that is correct.
Hi now isn’t there some sort of oath taken by advisors where they need to provide all information available including the DSCs. And if not how do reps sleep at night bye not letting the investor know about these fees (especially the not so rich clients). Just currious is all as I am a fairly new investor working in the financial industry
DSC funds do have their place. Registered accounts where the smaller investor is in it or the long haul, such as RRSPs or LIRAs, possibly TFSAs or cash accounts depending on their investment objectives. Provided that the client is invested in a quality fund company with a large basket of funds on different mandates, no fee switches cost the client nothing and allow for shifting market positions.
Clients who may plan to remove their funds in the medium term, however, are not candidates for DSC at all. Clients are well known for forgetting full disclosures of the fee structure when the sticker shock comes because they all the sudden decided they want to yard out half their RSP for a first time homebuyers plan, for example. Smart firms are now making clients sign a disclosure if they are in a DSC – the he said she said and the industry regulator’s bias against DSCs make this a smart move. If I was to offer a client a no cost DSC vs. a 1% front end load, they would take the $1000 invested over $990 almost every time because everyone hates paying fees for anything (not just advice).
The IIROC is also overpowering the CSA because of the power of bank owned brokerages and the CBA controlled bank branches. Bank branches provide practically zero service and it’s as simple as popping in a few questions in a questionnaire and the reps usually have little time nor experience to evaluate market conditions. IIROC dealers are constantly pushing their reps to create higher and higher account minimums and go strictly fee based.
I think fee based is really the way to go, but as said in the article, you couldn’t even get an IIROC dealer to set you up on a fee based account with an initial investment of $25,000 or even $50,000 – they’d slam you into straight transactional. Well on trades of that size you might be paying 2-3% to buy then 2-3% to sell – for a total of 4-6% on entry and exit – ironically around the same as a DSC. That is if they’d even take your account at all. You could go discount but again then your getting zip for advice.
I think the sub $250K client market is terribly underserviced. In choppy sideways markets like we’ve seen recently advice is invaluable. When the rising tide floats all boats, sure low cost index funds work; but there certainly is value in having someone at the helm picking solid companies that can weather storms due to earnings and balance sheets rather than overdiversifying and just buying a little bit of everything. As they say, you can be some things to some people but not all things to all people. Index funds are very much proof in the pudding of this.
At the $500,000+ range a 1-1.5% discretionary model works. The advisor gets paid a reasonable amount for the service a client of that size deserves, non registered accounts get the fees deducted from their taxes and everybody wins.
Sub $25,000 clients are just in asset accumulation phase; they need to keep saving, not worrying about advice. They could put their money in money market or GICs and forget about it as long as they keep saving because their net return in dollars is negligible unless they are taking big risks. It’s the $25,000-$150,000 clients who are getting screwed today.
In this target range DSCs make sense in the right situations.
Advisors who are pushing clients to remortgage their homes and throw $500K plus into DSCs (*cough* Investors Group *cough) and calling it leverage are straight up crooks that make us all look bad. The key to any leverage strategy is an exit strategy – and if you could lose 5% just to exit when things go south you eliminate probably everything you gained from the strategy if not more. Anyone taking on debt to invest needs their investments liquid so they can close the arbitrage.
I think it is the final strategy I described that made DSCs look like the big bad wolf and put it on the radar of the regulators. The other way advisors screw clients is to redeem any free units they earn over time and buy another DSC fund. That’s not what DSC is good for at all; I worked for a SMI team that did that and it made me sick to my stomach – clients with $125,000 and 60 DSC positions under $5,000. I quit.
They key is to know what the client wants from their money. If someone has a $25,000 LIRSP and they’re 29, they can’t pull the money for 20-30 years anyway. In this case a DSC is a perfect choice. All the growth and none of the fees (provided the MER isn’t unfair).
Newbie here, finally going out on her own and leaving Investors group. In regards to question 4, I’m getting told by my advisor “The 10% fee free, as common in the entire industry, is only available for take- out provided it is spread over a 12-month period. Hence after the 12-month spread-over amount is taken out, then your leftover will see a lowered balance in your portfolio plus further maturity of units that can become available and hence a resultant lower DSC amount.”
I want to take the money out in the next month as many articles have said “rip the band aid off quick, pay the DSC and get the heck out vs. waiting for DSC to mature”.
I understand the info in your article to mean that if I have a portfolio worth $110,521 that has DSC’s attached, I would multiply this by 10% ($11,052) and subtract it to give me a total of $99469 that I would pay DSC’s on? I seem to be missing something. Can someone explain to me in newbie terms pls.
If I want to get out of Investors group asap, I’m guessing I should redeem the 10% amount vs switch it to a non-DSC version of the fund?
Thanks!