investing

Dealing With Mutual Fund Deferred Sales Charges

August 14th, 2014

Stay up to date

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

In the previous article, we discussed the different types of mutual fund fees and how you can find out about such fees. In this article, were going to explore what you should consider if you do have mutual funds with a DSC penalty, but want to switch out of them.

First however, a quick note on how DSC schedules work.

How DSC schedules work

Mutual funds are typically structured as a unit trust. All this means is that when you buy a mutual fund, youre buying units of that mutual fund trust. The trust in turn owns all the investments which the fund manager is continuously managing to produce investment returns.

In most cases, DSC schedules are attached to the initial units you purchase, not the dollar value you initially invested. What this means is that if you put $10,000 into a DSC mutual fund and bought 1000 units of the fund, your DSC fee and schedule stays attached to those units throughout time.

So if units go up in value in a year to lets say $11,000, that means your DSC fee is now tied to $11,000, not the original $10,000 invested. Make sense?

However, if your portfolio produces interest or dividend income that is automatically reinvested, that income will purchase new units which should not have a DSC schedule attached to them.

Im sure this is confusing, but the point being that if you want an accurate DSC penalty, just call up your investment company and request it.

So youve placed a call to your institution or advisor, found out what your penalty is, and you still want to leave them. Maybe youre uncomfortable with paying that penalty upfront, and you want a way to know whether its truly worth paying now or later. How do you decide?

If we approach this question mathematically, the real question becomes, will you make up the DSC penalty by investing in a portfolio of index funds and ETFs (e.g.MoneyGeek's model portfoliosand others) in that timeframe?

Case Example

Sharon has $52,500 invested in a mutual fund portfolio with a DSC schedule. Shes currently in year 3 of her schedule, and her initial investment was $50,000, which is what her DSC schedule will be based on. The growth she received was from dividend income and so isnt included in the DSC schedule, which is as follows:

PERIOD

DSC %

DSC AMOUNT

Year 1-2

5.5%

$2,750

Year 3

5.0%

2,500

Year 4

4.5%

$2,250

Year 5

4.0%

$2,000

Year 6

3.0%

$1,500

Year 7

1.5%

$750

Year 8 or more

0%

0

Since shes in her 3rd investment year, if Sharon removes her money from the mutual funds, shell pay a DSC fee of $2,500.

She wonders if she will make up that $2,500 penalty by having her money in an ETF portfolio over the next 5 years. Will the portfolio outperform her mutual funds by $2,500 (5%) over the next 5 years?

To be honest, no one can answer that question for Sharon with any level of certainty. Every situation is different, and no one knows what the markets will do. But we can still look at whats likely, and draw some general conclusions.

Sharon has two choices. She can leave her money in the mutual fund portfolio, or she can suffer a $2,500 penalty and move the remaining $50,000 to manage on her own.

Let's completely ignore performance numbers for the time being. We won't make any assumptions about which portfolio, the ETF or mutual fund, will do better. We just want our analysis to concentrate on fees for the time being.

Sharons mutual fund portfolio has an annual MER of 2.5%. That means Sharon is being charged $1,312 per year ($52,500 value x 2.5%).

The MoneyGeek portfolio, with a similiar historical risk level, is composed of individual exchange-traded funds (ETFs) whose average MER is 1/10th that cost, or 0.25%.

If she removed her funds and paid the DSC penalty of $2,500, and moved the remaining $50,000 to an ETF portfolio, her new fees would cost her $125 per year ($50,000 x 0.25%).

To be fair, we have to also include a MoneyGeek membership cost of $50 per year (including tax) and about $50 in trades per year. Thats a grand total of $225 per year:

ETF Portfolio = $125 ($50,000 x 0.25% MER)

+ MG Membeship = $ 50

+ Annual Trades = $ 50

= TOTAL $225

So for Sharon, self-managing her accounts using a moneygeek portfolio would be $1,087 per year cheaper than the mutual fund portfolio

Mutual Fund Fees = $1,312 ($52,500 x 2.5%)

- MG Total Costs = $ 225

Net Fee Savings = $1,087

That means over the course of 5 years (ignoring any growth), she would save $5,435 in fees compared to her mutual fund portfolio ($1,087 x 5 years remaining on DSC). Of course, if you go with a free model portfolio such as the Canadian Couch Potato's, the savings becomes even greater to $5,685. (For differences between MoneyGeek and Couch Potato portfolios, see this article).

However, lets not forget her DSC charge of $2,500 if she moves her money out of the mutual fund portfolio. That means that although she is saving $5,435 in fees over a 5 year period, shes losing $2,500 right off the top, meaning her net savings on fees would now be $2,935

Net Fee Savings x 5 yrs =$5,460

- DSC penalty = $2,500

= Net Savings inc. DSC = $2,935

So what we can say with some certainty is that the fees Sharon will pay, even if she suffers the $2,500 DSC penalty, will still end up being $2,960 cheaper over 5 years.

Weve purposely left out performance, and concentrated only on fees. This is because, with all things being equal, its rare to see a mutual fund beat an index over time.

However, one fundamental reason why mutual funds rarely beat an index is because the fees on mutual fund portfolios are so high. They come straight out of your investment account, and lower the overall investment return. Every year Sharon pays $1,087 in fees, thats $1,087 that isnt there growing, and isnt subject to compound growth over time.

So without talking about performance, we have covered it indirectly through the question of fees, which as you can see from the analysis above are fairly significant.

If we make the assumption that an ETF portfolio of a similar risk tolerance to Sharons current mutual fund portfolio gives similar performance numbers before fees, then we can say that paying the DSC fee and investing in the ETFs should put more money in her pocket.

Some would argue that although the ETF portfolio costs less, if the performance of the mutual fund is very good, it could easily justify those management costs with gains. But is this possible?

It really depends on where your money is invested, and how actively managed your mutual fund portfolio is. If you look at history, the chances of mutual funds beating the indexes over time are fairly slim.

In Sharons case, she feels the fees she is paying dont justify the advice shes getting from her financial advisor, whom she rarely sees. She hasnt had any planning work done, and the only thing her advisor spoke with her about was why these are good mutual funds. Shes deciding to save on the fees, pay the DSC charges, and stop paying an advisor for work hes not doing.

Conclusion

If you dont have any fees to sell your mutual funds, transferring to an ETF portfolio will save on fees, which will likely mean greater returns. The cost savings on the fees are very significant and have a compound growth effect.

If you do have fees, I think theres a very great chance that youll still end up better with a ETF portfolio, though no one can say for sure. You need to decide whether youre happy with the services youre getting for the fees youre paying.

If you decide you want to move your mutual funds over to Questrade, stay tuned for the next article, which is an article/video combination that will show you step-by-step how to do this.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.