January 10, 2011, 5:00 am

Mutual Funds Penalty Fees – To Switch or Not to Switch

by: The Financial Blogger    Category: Investment, Market and Risk
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Now is the time to think about your investment portfolio… It’s RRSP Time! Sooner or later, your financial advisor will call you to make an appointment for your RRSP contribution. But more importantly, you may be solicited by another bank or you may be not satisfied with your investment. However, you have a big problem; you have mutual funds penalty fees! So the question you keep asking yourself is;


Should I sell my funds and pay the penalty fees? Or Should I keep my investment portfolio as is?


This is always a tough question to answer. Why? Because if you answer sell, you’ll have less money in your pocket and nobody likes that!


The point of having deferred sales charges (DSCs) on Mutual Funds


You may ignore it and that’s a shame for your financial advisor, but you might have deferred sales charges on your mutual funds. What is this? This is a “penalty fee” if you sell your mutual fund and leave before X number of years. It can be 2 or 3 or your nightmare can go up to 7 years (any Investors Group clients around?).


Deferred sales charges exist because financial advisors want to get paid. When you think about it, it makes sense. You don’t pay your financial advisor for advice and this guy needs to pay his bills as would anyone else. As a general rule of thumb, you can expect an independent financial advisor to receive between 3 and 4% commission on an investment. Therefore, if you invest 100K with your advisor in mutual funds, he will make between 3 and 4K.


The problem is that the funds will generally have a 2 – 3% management fee (MERs). Since we have to pay people to manage your money on top of the advisor, you can understand that there is not enough revenue generated by the MERs to pay everyone. This is why the mutual fund company pays the advisor upfront for the “future” revenue generated by the investment. If you leave before everybody has made their money, you have to pay the bill. This is why you have deferred sales charges.


Want To Get Rid Of Your Deferred Sales Charges? But Don’t Want To Pay The Price?


The problem with deferred sales charge funds is that they usually have high MERs on top of that. You may have read that mutual funds MERs make them less attractive than Vanguard ETFs or other investment products. I would say that depending on your level of financial knowledge, mutual funds can be a good pick. However, it doesn’t mean that you have to pay deferred sales charges and high MERs!


The problem is that the penalty fee linked to selling your funds should be enough to discourage you from switching funds. However, you must make your calculations first if your want to know if you should do it or wait. Here’s what you need to take into consideration:


#1 Your current asset allocation (is it optimized? Balanced? Properly diversified? According to your investor profile?)


#2 Your relationship with your financial advisor (if the guy does an amazing job, keeps you up to date, shows you the latest products and strategies that fit your needs, it may worth it to pay a higher MER until the deferred sales charge has been eliminated.)


#3 The Deferred Sales Charge Amount (you might have an approximate idea but if you want to go further, you must know the real number. You need to know how much and for how many years you are stuck with them (most of them have regressive fees))


#4 Your Current Management Fees (you also need to know how much you pay in management fees annually to know how much you could save if you transfer)


#5 What you can get elsewhere (switching out your mutual funds is one thing but you need to know which kind of investment strategy you are swithching to)


#6 Look at point #1 to #4 with another advisor (analyze your future portfolio with the same standards to know if you are making the right move or not).


An example on switching out and paying your deferred sales charges


I have this case from a while ago:


-$200,000 invested in 1 single dividend fund at 2.50% MERs with $8,700 in deferred sales charges with 4 years left.


– The current asset allocation did not fit anymore (the client has a balanced profile and has no investments in US and international markets)


– The relationship with the advisor was ok but not more than that


– We could build a balanced portfolio with an MER of 1.50%, no deferred sales charges and a much better diversification.


– Therefore, by switching immediately, the client was saving $2,000 per year (which is 2.50% – 1.50% MERs * $200K). The client was also winning in terms of asset allocation and potential return. In this case, the client decided to go ahead and transfer. However, it’s not always the best move to make. It’s a case by case decision.


Another way to save on MERs


If you manage your portfolio by yourself with a brokerage account and you have some mutual funds, you might be paying too much in MERs for nothing. I found that Questrade is offering to reimburse a part of the fees! In fact, they offer to reimburse the trailer fees paid to them. Here’s more info from their site:


“Most mutual funds pay the trailer fee directly to the brokerage where your funds are invested. You will never see the trailer fee deducted from your account because it is typically embedded in the fund’s MER (Management Expense Ratio). The average trailer fee is about 1%. The specifics of the fees charged by a fund are detailed in the charges and fees section of the simplified prospectus.


With Mutual Fund Maximizer, you get back your trailer fees.
Questrade’s Mutual Fund Maximizer will put a stop to the unlimited fees charged by mutual fund companies by reimbursing trailer fees back to you.”


So you could build your portfolio and pay less simply by switching over to Questrade. RRSP season is the best time to review your portfolio. If you have mutual funds in it, you are probably paying too much right now. Take a look at your portfolio before making your RRSP contribution 😉 In addition to reimbursing the trailer fees, Questrade is also offering $50 in free trades if you open your account now….and you could win a $5000 pro trader course!


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