Converting mutual funds: The benefits, the risks and the costs

Our current RRSPs are in mutual funds (one of the three largest mutual funds companies), all DSC back-end loads with high MERs (2.5% in most cases). Hence, we are locked in with early redemption fees, which came as a surprise to us.

We are considering moving to an online brokerage account and opting for an ETF for our RRSPs.

Our current RRSPs are held with DSC fees, in case of early redemptions. We don’t see an option to negotiate this, nor do we want to move these to another fund that will not have strings attached. I was wondering if you could clarify the costs, as we are considering moving to an online brokerage account and opting for an ETF for our RRSPs.

Thank you in advance for taking the time. It will hopefully help clear up our anxieties and point us to a better direction.

–P.N.

Should you convert your mutual funds into ETFs?

P.N., you’re asking a lot of good questions about mutual funds sold with deferred sales charges (DSC).

You may be interested to know that soon all Canadian provinces will be banning the sale of mutual funds with DSCs. However, the ban does not apply to segregated funds sold by advisors with a life insurance license.

If you are an investor who normally invests in a mutual fund through an advisor, and your advisor suddenly suggests you should start investing in segregated funds, your spidey senses should be tingling. Let me start by explaining how DSC funds work.

What are DSC and FEL fees? 

There are generally two sales options a non-fee based advisor has, front-end load (FEL) and DSC.

With the FEL, the advisor can charge you 0% to 5% up front, which comes directly from your investment. So, if you invest $100,000 and the charge is 5%, your initial investment will be $95,000. Your advisor/dealer will also earn 1% (a.k.a. a trailing commission) each year which is explained in more detail below. I don’t know of an advisor that charges a client a FEL fee and, from what I have seen, it is common practice for advisors to provide FEL funds with a 0% commission. You could have asked for this option rather than the DSC, if you knew it was available to you. There is no penalty to redeem from an FEL fund.

DSC funds, on the other hand, provide a way for the advisor to earn the 5% commission without it coming out of your initial investment. If you make a $100,000 investment, the mutual fund company will pay the advisor’s dealer/employer 5% of the original investment, or $5,000 in this case. Generally, the advisor’s dealer will keep 20% of the $5,000 and the remaining $4,000 is passed along to the advisor.

But that’s not all.

Redeeming mutual funds

The advisor/dealer is also paid an annual trailer commission of 0.5%, pro-rated monthly based on your current investment value. In this case $500 minus the 20% to the dealer being $400. Your full $100,000 is invested, but the fund company needs you to keep invested for at least seven years, so it has time to recoup the commission it paid to your advisor/dealer.

If you decide to redeem your investments from the fund company before the seven years are up, you will be charged a penalty, which reduces each year until the DSC maturity date when you are free to withdraw your investments without penalty. There are differences between the fund companies as to how the penalties are applied so it is best to check their respective prospectus.

And, remember, if you are making monthly contributions into a DSC fund, each new contribution is locked in for another full six years before it can be withdrawn without a penalty.

Can you redeem mutual funds without paying a penalty?

Luckily, there is a way to get some money out of mutual funds without penalty, there has to be. Imagine if you were retired and had to pay a penalty every time you drew on your account.

Each year, you’re able to draw 10% of your DSC funds total units out without a penalty. Note that when you purchase a mutual fund you are purchasing units of the fund as opposed to shares of a stock.

My recommendation is that you take advantage of this 10% each year. If you like the fund you are in, ask to have all of the free units of your DSC fund moved to the front-end version, FEL, of the same fund with a 0% commission. I say free units because it is possible that more than 10% of the fund is free of DSCs.

Your advisor should not object to this because their trail commission on the front-end version will increase from 0.5% to 1%.

P.N., as you plan to leave the fund company, you can have the option of the free units going to the front-end version of the fund so you can sell when you’re ready, or have the free units go to cash.

Again, ask for “all free units,” just in case some of your original purchases are past the seven-year mark making them free of charges meaning more than 10% of the units may be free.

Exit strategy with DSCs

To your question if you should pay the DSCs and move on, this is a little tricky to answer.

Ask your advisor these questions:

• What is the DSC penalty? 
• What is the DSC maturity date?
• How many free units do I have now?

The only reason to switch out of the DSC funds and pay a penalty is because you think you can go to a lower cost fund that will not only perform better than your current funds, but also perform well enough to recoup the costs of the DSC fees.

Is it an investing strategy or just luck?

There is a lot of luck involved with investing, especially when it comes to earnings in the short term. And just because another fund is less expensive, it doesn’t mean it will outperform the original fund. 

Take the example of flipping a coin for heads or tails. Each flip has a 50/50 chance of heads or tails. This is similar to investing, each year you have a 50% chance of beating the market average, assuming no investment fees.

A coin tosser has a 12.5% chance of flipping heads three times in a row and a 3.1% chance of heads five times in a row. How do you think those returns compare to an investment professional trying to beat the market average? If investing is a game of skill, we should expect better returns over one, three and five years, right?

The S&P Indices Versus Active Data shows the number of active Canadian equity funds beating the average market rate of return over one, three and five years, ending June 30, 2021, as 40.43%, 5.56%, and 4.29% respectively. That’s pretty close to the coin tossing results, which we know is pure luck.

Paying DSC fees

Back to your question about cashing out and paying the DSC fees. It is up to you, it’s guess work. You can avoid the penalty by moving out slowly with the free units, or you can pay the DSC penalties, start fresh, and hope for a bit of luck. 

To quickly answer your other questions, you can hold as many exchange traded funds (ETFs) in your portfolio and trade on different exchanges if you like. Do you need to? If you have been reading the pages of MoneySense you’ve seen that the simple couch potato portfolio has done just fine.

I hope this helps, P.N.

Letter was edited for space and clarity.

Allan Norman, M.Sc., CFP, CIM, RWM, is a fee-only certified financial planner with Atlantis Financial Inc. and a fully licensed investment advisor with Aligned Capital Partners Inc. He can be reached at atlantisfinancial.ca or [email protected].

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About Allan Norman, MSc, CFP, CIM

With over 30 years as a financial planner, Allan is an associate portfolio manager at Aligned Capital Partners Inc., where he helps Canadians maintain their lifestyles, without fear of running out of money.

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