DSC purchases
Three reasons why they may disappear

The late-1980s gave birth to the deferred sales charge (DSC) purchase option for mutual funds. While the introduction of DSC funds coincided with the booming growth of the fund industry, there are good reasons to expect its popularity to wane - and maybe disappear.

Background

Little more than fifteen years ago, it was common for advisors to charge clients a front-end load of nine percent on all mutual fund purchases. Critics of this structure argued that it promoted 'churning' of client accounts. In 1987, Mackenzie Financial unveiled the DSC purchase option, which not only gave advisors an initial payment, but a small annual fee for ongoing service.

This had intuitive appeal since a new relationship between client and advisor usually entails a lot of work in the earlier stages. So, an up front fee made sense - as did the smaller annual fee.

Soon, all fund companies choosing to sell funds through advisors followed suit, introducing DSC versions of existing funds - which ultimately lead to fee hikes to enable fund companies to finance the increased cost.

However, the following three trends all point to - at the very least - a significant drop in DSC sales, and maybe waving goodbye to that option altogether.

Consolidation

As noted in last week's column, the fund industry remains in the consolidation phase. Just imagine having invested a significant amount of money for a client in, say, Synergy funds on a DSC basis just weeks before the announced takeover by CI Funds.

Mergers of fund firms always result in some product consolidation, which means the manager you bought may no longer be around. However, the DSC purchase just committed that investment to the firm for a full six or seven years.

No investor wants to feel trapped, particularly when the manager with whom the money was invested (often a key factor) no longer manages the fund.

Wooing high net worth clients

Thanks in part to a tighter regulatory environment, operating costs for distributors (i.e. advisory firms) have risen. This has lead some firms, and most individual advisors to focus on marketing to the industry's most coveted client - i.e. the high net worth individual.

I would consider those with $500,000 or more of investable assets to be a member of that highly sought after group. Some might set the bar higher, at $1 million. Either way, the fact that every advisor is pursuing wealthy Canadians, which leads to a couple of reasons why DSC fund sales just don't have a place here.

Competitive forces are somewhat in favour of the high net worth client. Suffice it to say that there aren't enough high net worth clients to go around. Hence, advisors will have to compete on service and price - while really excelling at one of the two.

Being competitive on price means there's little chance DSC funds will be feasible for wealthy clients. Just think of telling a $1 million client that you'll generate $50,000 in commissions, up front, from investing her money. Most advisors would be hard pressed to justify such a healthy payout based on the work performed on the client's file up to that point.

The other issue is one of client retention. A large portfolio invested mostly or entirely in DSC funds is easy pickings for competitors. Another advisor can easily pick apart such a portfolio with heavy criticism - and it would start with fees and commissions.

Advisors wishing to compete in the high net worth space have to be sensitive to fees and commissions in dollar amounts because one way or another the client pays for it.

Increased scrutiny

Not only will competing advisors scrutinize portfolios, but so will investors as they become more educated and aware - due in part to increased regulation. Further, with high net worth investors, portfolio proposals must often be presented to the client and his accountant. In this case, documentation can be critical.

I worked on a case this past spring whereby an advisor was to propose a portfolio for a $1 million account. The client insisted that her accountant be present. I designed a portfolio and drafted an investment policy statement. A small amount of DSC was recommended but it was an amount that was determined according to the work required up front for analysis, client meetings, and implementation.

Every detail was documented and fees were the first issue addressed. The accountant was impressed as was the client, who later accepted the proposal. In such a case, a significant amount of DSC would have been tough to justify.

Looking forward

These issues aside, a variant of the old DSC is gaining popularity - the 'short DSC' or 'low load' option. This involves a commission payment of 1 to 2 percent, plus a trailer fee that is equal to that applicable on front-end purchases. It's not a bad compromise since it provides an up front payment but only ties up the client for two to three years - rather than for six or seven years.

The trends noted above present a good case for why DSC fund sales are likely to dissipate as the industry evolves. Advisors would be smart vto prepare now for changes before they're forced to adjust.