Investors lack basic knowledge

Much has been written over the years about the toll taken on mutual fund returns by high fees. But despite all the publicity, it appears that most investors either don’t get it or don’t care.

A study conducted by The Brondesbury Group for Ontario’s Investor Education Fund (IEF) found a shocking lack of knowledge or understanding of how financial advisors are compensated when they sell mutual funds. The recently published report concluded that most investors “have little or no idea” that their advisor is receiving both sales commissions and trailer fees when a fund is added to a portfolio.

“Even when the full range of fees and what affects them is identified, it is difficult for investors to assess the implications of what they have learned,” the report found. “Issues of potential conflict of interest are particularly difficult to consider, since they are counter to the high level of trust that underpins their advisor relationship.”

The study was conducted online between Dec. 15 and Jan. 5 among investors who have financial advisors and have purchased mutual funds through them. About 2,000 people responded for an accuracy rating of +/-2 per cent.

Some of the findings suggest that far too many investors have almost no understanding of the costs they are paying. For example, 22 per cent of respondents disagreed with the statement that advisors “get paid a percentage of the mutual fund cost when they buy a fund for you” while another 44 per cent didn’t know. Only about one-quarter of investors believed that front-end sales commissions are negotiable.

In response to another question, 20 per cent disagreed with the suggestion that mutual fund companies pay advisors an annual amount to provide clients with service while 49 per cent didn’t know. (Such payments are called trailer fees).

“When asked about disclosure of trailing commissions, only one-quarter believe these commissions were disclosed,” the report said. If that reflects reality, or anything close to it, most advisors are failing to fulfill their moral disclosure obligations to their clients.

After learning about the various fees attached to mutual funds, investors were asked whether they felt the commissions put the advisor in a conflict of interest situation. Only 13 per cent said yes. About half the respondents didn’t know while 36 per cent said the advisor would look out for their best interests, no matter how he/she was paid.

“Investors trust their advisor to provide advice that benefits the client first,” the study concluded. “This trust is underpinned by a belief that their advisor has a legal responsibility to ‘put the client first’. With this as a foundation of investor belief, investors find little reason to be concerned about fees, which they have little knowledge of.”

In fact, financial advisors in Canada do not have any fiduciary responsibility to put the interests of their clients ahead of their own. And, despite the growing debate on this issue, that’s not likely to change in the near future.

Accordingly, the report recommends that fee disclosure be made mandatory. “Requiring disclosure of fees will ensure that the one-quarter to one-half of investors that learn about fees now will extend to everyone,” it says. “Once fees are disclosed, it will give investors the time and information to understand what they are paying for. 

“Given the broad range of planning and investment advice provided by advisors and the reliance that investors place on this advice, we do not believe that disclosure will be detrimental to the industry in the long run. In fact, it could help establish the principle of paying for advice rather than transactions – a principle that is beneficial when dealing with an aging population that is likely to transact less in the future.”

Tom Hamza, president of the IEF, suggests that the fact investors don’t understand the legal nature of their relationship with their advisors is “the root cause of the problem”.

“In your interactions with your advisor, you have to realize there are interests on the other side of the desk that must be considered,” he said. Ask exactly what products the advisor can and cannot sell and get a complete breakdown of the expenses involved in any recommendation, he suggests.

“Costs are one thing you can control,” Mr. Hamza said. “Ask if there are any alternative products that are less expensive.”

The message for readers to take away from this is two-fold.

First, do not assume that your financial advisor is always acting with your best interests at heart. You are in a business relationship with this person so don’t be afraid to ask hard questions and to negotiate where appropriate. For example, insist that the advisor never buy deferred sales change (DSC) mutual funds and ask for front-end load funds to be purchased at zero commission. Your advisor will be compensated by the trailer fee, which you pay through the fund’s management expense ratio (MER).

Second, make sure you understand all the costs involved in a product. This does not apply only to mutual funds — there are expenses attached to almost all financial products. Exchange-traded funds (ETFs) are considered cheap investments but when you add brokerage commissions to the MER (which in some cases is surprisingly high) the cost adds up. Be especially inquisitive about insurance products and scholarship trust RESPs: some may look very attractive but when you add up all the costs involved you may decide to seek other alternatives.

Photo © kali9

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