With your Mutual Fund you also get a Trailer
An Introduction to Investment Planning – Part 5.3
Why is there a trailer hitched to my mutual fund?
Included in the Management Expense Ratio or MER of many mutual funds is a trailing commission or trailer that is paid to the firm where you have your mutual fund account. This is intended to compensate the mutual fund salesperson who sold the fund to you for ongoing advice. There are a couple of problems with this. First, how much advice are you getting from the salesperson after the fund has been sold? Second, if the advice is of a different sort, if it has to do with financial planning rather than investment purchases, for example, why does the mutual fund company pay the salesperson for doing something unrelated to the mutual fund? It doesn’t make a lot of sense. Many are now advocating for the elimination of trailing commissions altogether. However, as this pattern has worked successfully – for the advisors – for decades, there are those who are loath to give it up.
Series D Mutual Funds
Mutual funds with a trailing commission have been the standard for decades. Trailing commissions were even paid to discount brokerages despite the fact that no advice is permitted to be given to clients of such brokerages. In recent years, mutual fund companies have created a special series of funds, the D-series, that are designed to be sold at discount brokerages. The difference is that the MER is greatly reduced. This is a result of the elimination of the trailing commission except for a small amount paid to the brokerage for the administrative costs of holding the fund.
Note: In the few days between the time I originally wrote this post and the publication date (2019-DEC-20), news has come out that Deferred Sales Charges (DSCs) and trailing commissions for discount brokers will be formally banned.
How do you buy a Mutual Fund?
Your local bank or credit union
If you are just getting started in investing, this can be a good place to start. Usually, you don’t need a large initial purchase, you can set up a pre-authorized purchase of additional dollars of the mutual fund on a periodic basis, and your bank representative will take care of all the paperwork for you. Be aware, though, that you will only be able to buy mutual funds that are affiliated with that particular financial institution. As your assets grow, you can consider alternatives to this option.
Direct from the Mutual Fund Company
Some mutual fund companies sell directly to their customers. Fees are usually, though not always, lower because they don’t have to market their funds to all the different intermediaries who sell their funds. If they sell directly to clients they are most likely also members of the Mutual Fund Dealers Association (MFDA).
Through a Mutual Fund Dealer
Dealers may or may not be affiliated with a mutual fund company. Regardless of their independence, they may choose to limit themselves to a certain number of fund families. You can find a list of dealers on the Mutual Fund Dealers Association (MFDA) website.
Through a Full-Service Broker
If your image of an investment advisor at a full-service broker is someone who is recommending stocks to you on a routine basis, that is probably not accurate. They will also sell mutual funds to you. An increasingly common approach is to sell F-series funds which strip out the trailing commission entirely. This allows the investment advisor to negotiate a fee directly with the client, usually under a compensation approach known as AUM or Assets Under Management.
As an illustration of the AUM approach, imagine if you had $500,000 in assets managed by your investment advisor. You and your advisor negotiate a fee of one percent, which means that you would pay an annual fee of $5,000 ($500,000 x .01). If your account goes up in value, you pay more; if your account decreases in size the fee also decreases.
Through a Discount Broker
You can also buy any number of mutual funds through a discount brokerage. The difference here is you are not getting any advice from the investment representative you are speaking with.
How to decide?
With that limitation in mind, the websites for the discount brokerages provide you with a variety of tools to help you narrow down your choices. You can get advice on using those tools effectively, but you still must choose the criteria that are important to you.
One of the more well-known mutual fund research organizations is Morningstar. You can sign up for a free account here. You can search for information on mutual funds that you are interested in through their website. However, your discount brokerage may have all that information and more if they’ve contracted with Morningstar as a vendor of services for their clients.
One of the important things that Morningstar has discovered is that, historically, fees are one of the best indicators of future relative performance. According to their mid-2019 Active-Passive Barometer report: “The cheapest funds succeeded more than twice as often as the priciest ones (33% success rate versus 14% success rate) over the 10-year period ended June 28, 2019.” This report undermines those who argue that “fees don’t matter” as long as the performance is there. The probability is that the lower the fee, the more likely you are to do better. To turn the idiom upside down, “you get what you don’t pay for.”
Mutual funds come in a variety of categories. This will be the topic for my next post.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.