August 14, 2005

The future of DSC funds
New structure could benefit fund companies, advisors, and investors

The significant reduction in the use of the deferred sales charge (DSC) sales option for mutual funds has been well documented. I have also written in the past about why DSC sales should be reduced (see DSCs on way out from May 2004). However, it's clear that commissions will be around for a long time and there's a way to change the DSC structure to benefit both mutual fund companies and fund unitholders.

Current system

Currently, a mutual fund sold on a DSC basis results in a commission of 4% (for bond funds) to 5% (for equity funds) up front - followed by an annual trailer or service fee of 0.25% (bond funds) to 0.5% (equity funds) per year. The MER remains the same throughout, with an exit fee applied to any investor leaving the fund family altogether (and paid directly to the fund company) within six years or so of each DSC purchase.

Industry critics and investor advocates call the system unfair since fund companies easily recoup the cost of the up front commission paid in well under six years. Plus, they argue, investors should get a break on fees after they've fulfilled their six years in a fund family. Extending this line of thinking could result in a system that is something of a win-win in situations where investors want and need advice.

The new DSC

My idea involves creating a new series of shares - let's call them D class shares - for each fund offered on a DSC basis. Once DSC units have fully expired, they'd be automatically converted to the D class shares of the same fund. D class shares could continue paying the same trailer fee to advisors but would carry a management expense ratio (MER) that is reduced by the cost of the up front commissions.

Generally, the up front DSC commission payment costs fund companies about 50 to 80 basis points annually. So, D class shares could carry a MER that much lower than that charged by the A class shares. If created, hypothetical D class shares of popular funds like Mackenzie Ivy Canadian fund, Trimark Select Growth, and CI Canadian Investment would have a MER south of 2% per year. But there's a catch.

Investors could not buy D class shares directly. The only way into them would be to first buy the regular A class shares on a DSC basis and hold past the redemption schedule. And investors could only switch over to them from other D class fund units.

Benefits of D class shares

Funds sold on a DSC basis are valuable to fund companies since they are typically very 'sticky' assets due to investors' hatred of exit fees. In a maturing fund industry with fewer sales into DSC funds, assets are more mobile than ever. Investors might actually stick around longer if the companies with which they entrusted their life savings actually gave them a monetary incentive to be a long-term investor.

So, fund companies would benefit by having more loyal investors. Fund investors would demonstrate such loyalty because they'd appreciate fund companies giving them something in return for their long-term patronage. And, advisors would continue to receive the same (0.25% to 0.50%) trailer fee for as long as their clients held those funds.

D class shares are seemingly a nice hybrid of the various structures in existence today but the current system is likely to resist such a move to some degree.

Industry resistance

There is a trend in place whereby fund companies automatically provide an escalating trailer fee on DSC fund units to reflect the annual 10% free withdrawal entitlement. And since front end load funds pay a higher trailer, automatically converting some or all of this 10% each year results in a slightly rising trailer each year. In today's competitive environment, offering advisors higher compensation - automatically - is an attractive feature when MERs remain constant.

Also, fund companies enjoy higher profit margins on matured DSC fund units since they continue to collect the management fee priced for a DSC structure - long after the DSC commission has been recouped. And companies with stronger fund offerings may not need to offer any incentive for investors to continue holding.

The proliferation of 'low load' fund units is a popular option that is starting to replace traditional DSC sales. These units also offer advisors slightly higher compensation overall, with no difference in MER.

Investors should have incentives to hold longer term and should be rewarded for letting a firm manage their life savings for a long period of time. Fund companies would take a margin haircut but have greater certainty of revenue since D class shares are likely to be stickier. Plus, advisors don't suffer a pay cut. Sounds like win-win-win to me.