Fees and Commissions
Unfortunately, there is nothing straightforward about the fees and commissions on investment products.
The financial services industry has done itself a disservice in the way that fees and commissions are disclosed. Many investors may be unaware that they are paying anything when in reality they may be paying abnormally high fees. It is one part of the industry that needs to be more transparent and simplified.
Investors should try to ensure that what they are paying reasonable. On the other hand, investors should not become obsessed with fees at the expense of making appropriate decisions.
Reducing fees does not guarantee superior returns, nor does it ensure that the risk in your portfolio will be reduced. A well-constructed portfolio with moderate fees is far better than a poorly constructed portfolio with low fees.
Fees are an easy target but in reality they rank lower on the list in terms of what affects portfolio performance. Five factors that affect the rate of return you can expect to achieve include:
- Asset allocation.
- Cash flow into or out of the account.
- Security selection – choice of investments.
- Timing of changes made to asset allocation (see the Dalbar study discussed earlier).
- Fees and commissions.
In order to provide some clarity, the complex world of fees and commissions needs to be examined in more detail. It can be difficult to absorb all of the variations and it is a good idea to mark this section for reference if you have any questions.
Trading commissions are those charges that are incurred when a transaction, either a buy or a sell, is made. Management fees are those fees charged on an ongoing basis for as long as they are held in the investor’s portfolio.
To further complicate matters, an investor can choose a fee-based account where there are no transaction fees and a management fee is charged on all products. Or they may choose a commission-based account where there is a trading commission but no management fee charged on some products but where a management fee may apply on other products.
If you aren’t confused yet, you are doing well.
Individual investments such as bonds, common shares and preferred shares have no management fee associated with them.
Investments that represent a basket of individual investments, such as mutual funds or exchange traded funds (ETFs) do have a management fee associated with constructing and managing the basket of investments on an ongoing basis.
These fees are referred to as management expense ratios or MERs.
Management Fees for Mutual Funds and ETFs
The following table provides some guidelines with respect to management fees on various products.
Keep in mind that these rates reflect rates that were in place in 2010
Commission based accounts
Common shares, preferred shares and ETFs are all traded on stock exchanges and trading commissions will apply on a buy AND on a sell.
These commissions will vary with the individual unit price, the total size of the transaction and the policy of the investment dealer. An annual management fee will also apply on ETFs but this charge is not seen on client statements. It can usually be checked on the website of the company that manages the ETF or the fund’s prospectus.
The following table is an example of the approximate commissions an investor can expect to pay when buying or selling exchange traded investments. Exchange traded investments include individual investments such as stocks and broadly based investments such as exchange traded funds (ETFs).
Keep in mind that these represent fees charged in 2010 – rates may have changed since then.
There are a variety of sales charges (commissions) that can be applied on the purchase or sale of a mutual fund. These charges, if applicable, are in addition to the management expense that is applied on an ongoing basis.
In summary, the various sales charge formats include:
No load – This commission is exactly as it sounds. There is no commission charged when you make the purchase and no commission or fees are applied if and when you sell the fund.
Front load – There can be a commission applied of up to 5% when a purchase is made but there are no fees or commissions applied upon the sale. In some cases, financial advisors will charge a commission of zero upon the purchase, in which case it is the equivalent of buying the fund with no load.
Low load – There is no commission applied when the purchase is made but a redemption fee will typically apply if the fund is sold within three years of purchase. If it is sold after that period, no redemption fee is charged. Each fund has a different holding period during which these redemption charges apply.
Deferred Sales Charge or Rear load – Similar to a low load, there is no commission applied when the purchase is made; however, the holding period can be as long as six or seven years before the redemption charges are eliminated. Funds cashed in before that time can have significant redemption charges, usually higher than the charges on a fund sold with a low load commission option.
With the low load or deferred sales charge option, investors can typically redeem up to 10% of their units each year without incurring a redemption charge.
This is where some of the transparency problems begin. Investors may be unaware or may fail to remember that these fees can apply on sales.
They are listed in the fund prospectus but the document is long and the fee schedule is often overlooked or forgotten.
The following table provides an example of the fees that are applicable under the various sales charge formats for mutual funds. While the actual charges will vary from one mutual fund company to another, the information in this table is a good guideline.
Low load and deferred sales charge options are becoming rarer each year.
Fee Based Accounts
With fee based accounts, investors are allowed a limited number of transactions without incurring any commissions. The number of trades is usually sufficient for any well managed portfolio. The trading limit makes this type of account impractical for day traders or very active traders.
The commission free trades apply to all exchange traded products such as common shares, preferred shares and ETFs as well as to mutual funds.
In fact, a special class of mutual funds with a lower MER is available for fee based accounts. They were developed to ensure that investors weren’t paying two management fees on the same product, one at the investment level and one on the account level.
Typically, an investor has a choice of a fee based account where a flat fee is charged, or one where the fee is higher on the equity portion of the account and lower on the fixed income portion of the account. Once again, the choices are confusing.
The following table is an example of management fees on fee based accounts where a flat fee is charged whether the investments are equities or bonds. Many investment dealers will also offer a tiered fee schedule and investors can inquire about the fee levels of each platform and decide whether either one of them meets their needs.
It may be that a commission based account is more suitable.
Investors should inquire about the fees they will be expected to pay on fee based accounts. There may be a difference among firms and advisors may have some latitude in the level of fees their firms allow them to charge. There may be room for negotiation; it never hurts to ask.
A Hybrid Account
The commission and fee structures available to investors will continue to evolve.
Perhaps a hybrid structure will emerge that would separate the charges for advice and for trading.
Each account would be subject to a commission for each transaction. This commission would be substantially lower than what is charged in a traditional commission based account, while the ongoing fee applied to each account would be substantially lower than what is currently charged in a traditional fee based account.
When it comes to fees and commissions, investors need to be aware of what they are actually paying and what a reasonable amount is. The tables are meant to be a point of comparison for fees.
What about bonds?
While it may appear there are no commissions in bond transactions, it would be naïve to assume the process occurs without any form of compensation. In order to understand this compensation, you need to take a closer look at how bonds are traded.
Unlike stocks where there is a centralized exchange to facilitate transactions between buyers and sellers, there is no equivalent exchange for bonds.
Investment dealers have a ‘bond desk’ or bond department that carries an inventory of bonds. Bonds are offered to clients from that inventory and when a client wants to sell a bond, the dealer buys it and adds it to their inventory.
It is not typically an exchange between two investors, as with stocks; it is a purchase from the dealer or a sale to the dealer.
This background will help you understand how commissions on bonds are charged.
But before talking about commissions, the pricing on bonds needs to be explained. Once again, it may not seem straightforward to the average investor. Bonds are traded in multiples of $1000 face value but the price is based on a base of 100, otherwise referred to as par.
A $10,000 bond trading at 100 would cost $10,000 not $1 million dollars. If the same bond was trading at 95, the value would be $9,500.
It is confusing for many people; however, it is worthwhile information. The following example illustrates this point:
An investor buys a bond with a face value of $10,000 and pays 99.50 for a total cost of $9950. The dealer may have purchased that bond earlier for 98.50 or a total cost of $9850 and held it in their inventory. The commission or profit on the trade for the dealer, in this case, was $100. The $100 never shows up as a commission but it is embedded in the price.
The investor receives their bond knowing full well what it will be worth at maturity and how much interest it will generate over that period of time. Upon maturity, the issuer of the bond, and not the dealer from whom the bond was purchased, redeems the bond and issues a cheque for the face value. There are no costs embedded into the redemption of the bond at maturity, nor are there any additional fees charged.
Summary of fees and commissions
Banks, investment firms and mutual fund companies are businesses. They employ people, they have costs and they are expected to generate a profit for their shareholders.
Canadian banks don’t make billions of dollars every year by giving away their services. With every product or service there is a fee that is either obvious or embedded. Investors can pretend they aren’t being charged if they don’t see a fee but there is always a cost to do business.
The solution is to be aware of costs and ensure that they are fair. However, fixating solely on costs at the expense of all other aspects of planning and saving for retirement can be counterproductive.
Most financial advisors are compensated on the revenue they generate through fees and commissions.
A typical investment dealer may keep 55% to 70% of commissions generated and pay the remainder to the advisor. The firm’s share covers costs such as branch office overheads, a share of head office expenses, investment research costs and so on.
The individual advisor often receives 30% to 45% of the total commissions generated. Their share of costs includes such items as licensing, advertising, marketing and sometimes a portion of their assistant’s salary.
- Fees and commission charges are not always transparent.
- Different commissions can apply to various investments.
- Management fees can be embedded in the price of a product without the investor realizing what the true costs are.
- There has been a movement towards greater transparency.
- Most advisors are paid a percentage of the fees and/or commissions collected.
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