Why self-directed investors should hate A class fund fees

A class action law suit filed recently against TD Asset Management serves as a reminder to all investors to be vigilant regarding costs. The claim relates to the industry practice of selling high-cost mutual funds through online discount brokers. It’s important to note that while this action targets TD, the issue is industry wide.

Mutual funds come in different “classes”, the most expensive of which are called “advisor class” or “A class” funds because they incorporate a fee for advice. The legal action against TD arises from the fact that billions of dollars of these high-fee, A class funds are sold through online discount brokers which do not, and by regulation cannot, provide investment advice. These A class funds are often offered side by side with “discount class” or “D class” versions of the same fund which produce higher returns because the advice portion of the fee has been stripped away.

READ:  About $195 million is going to discount brokers, instead of you and me

Many investors make the mistake of buying more expensive, lower return A class funds through discount brokers. Perhaps they assume that, as discount broker clients, they will always be provided with lower-cost products. There are exceptions, but with most discount brokers, this is not the case when it comes to mutual funds.

What is the potential impact of this practice on an average investor? Let’s consider an investor putting $2,500 into the TD Dividend Growth mutual fund each year for 20 years.

If we assume the average annual compound return of the TD Dividend Growth Fund over the next 20 years will be 6% before fees, the investments within the fund would grow to $97,482. If you purchase a D class version of the fund, you would be left with $84,922 after the cumulative deduction of the 1.19% annual fees (MER) whereas an investor purchasing the A class version of the same fund with a MER of 2.02% would end up with only $77,248.

READ: How mutual fund fees work

In this example, the D class investor retains 74% of the total gains of the fund while the A class investor retains just 57% of the total gain, with the balance lost in fees.

For many years, investor advocates have been calling for the practice of selling A class funds through discount brokers to be banned. While regulators have expressed their distaste for the practice, no concrete action has been taken to protect investors. Until the regulators or the courts act, investors must protect themselves. If you choose to buy mutual funds through an online discount brokerage, make sure you buy lower cost D class funds and keep more of your investment returns for yourself!

Of course, index ETFs are an obvious, much lower cost alternative to mutual funds for online discount brokerage investors. Let’s again look to TD for an example. Assuming a similar 6% average annual compound return and $10 commission costs on each annual purchase, the TD S&P/TSX Capped Composite Index ETF with a MER of 0.08% would generate a total value of $96,188 after 20 years ($50,000 invested and $46,188 gained – 97% of gain retained).

READ: Are fund fees worth 35 times the amount you pay to DIY?

How will the TD ETF actually perform against the TD mutual fund? We can’t be sure but a comparison of top holdings gives us a clue. The majority of both funds are invested in a small number of prominent Canadian stocks. In fact, as of December 31, 2017, the 9 of the top 10 stocks in both funds are identical. They are the big five banks, Enbridge, CN Rail, Suncor and TransCanada.  If this similarity continues we could guess that returns might also be similar before fees and that the outcomes are highly likely to favour the lower-cost index fund after fees.

Regardless of whether investors choose online discount brokers or traditional advisors, the lessons are simple:

1. Know exactly how much you are paying in fees
2. Understand the long-term impact of fees
3. Make sure the services you receive are worth the price you pay now and over time

MORE ABOUT FEES:

• An investor’s guide to getting what you don’t pay for
• Some tough questions to ask your advisor
• Should my teens be investing with a discount brokerage?