F is for fair deal

It seems prehistoric, but even 10 years ago you couldn’t always go out and buy the mutual funds that would have made the most sense for your portfolio.

You were restricted by your adviser. If you employed a commission-based adviser, you could buy only funds that charged a “load,” or commission, because it was that commission which eventually got recycled back into your adviser’s wallet as his compensation for giving you advice.

Investors were suspicious of this arrangement and with reason. While most advisers wanted to do the best for their clients, you never knew if your adviser was recommending a fund because he truly thought it was the best option for you, or because the fund had promised to pay him a big commission.

On the other hand, if you wanted to avoid this conflict of interest, your choice was limited. You could hire a “fee-based” adviser and pay her directly for her advice on “no-load” funds that didn’t charge a commission. This arrangement removed any conflict of interest, but it was a headache in practice because your adviser couldn’t sell you the no-load funds directly. You had to purchase the funds yourself by either going to the fund company—which was inconvenient—or by going through an investment dealer, which entailed paying the broker a commission in addition to the adviser’s fee.

It was a silly, awkward system. But finally the mutual fund industry saw the light. Beginning about five years ago, it introduced so-called F-series funds that you can buy through fee-based advisers. These funds allow you to separate what you’re paying your adviser from what you’re paying the fund company. That means you no longer have to worry that your adviser is recommending funds on the basis of how much the funds pay him.

I think F-series funds are a great idea. They make fees transparent so you can hold your adviser accountable for the quality of the advice he or she is delivering. In addition, these funds charge much lower management fees than their rivals since they’re no longer paying commissions to advisers. The lower fees mean that more of the portfolio’s profits can find their way into your wallet. Finally, the F-series fee structure makes it easier to drop an under-performing fund since you no longer have to pay back-end loads to exit a loser, or shell out commissions to buy a new fund.

My one caution is that F-series funds aren’t always guaranteed to be your best value, especially if you’re working with a smaller portfolio. Your fee-based adviser has to earn a living somehow, so you typically agree to pay him either an hourly fee or a percentage of your portfolio’s value in exchange for his advice. This removes any conflict of interest—but depending upon how much your fee-based adviser charges, you can actually wind up paying more in total to own F-series funds than traditional funds. Before making any decision, you should add in the cost of your adviser’s fees to the management expense ratios of your F-series funds to calculate the all-in cost of ownership.

When I researched this year’s Honor Roll of mutual funds in our February issue, I excluded F-series funds because it’s impossible to know the all-in cost of owning them for each individual. The total cost of ownership depends upon how much your adviser is charging you, so it would be unfair to compare F-series funds to standard mutual funds, straight up.

I’ve decided to rate the F-series funds separately. To do so, I followed a similar approach to the Honor Roll process, but because F-series funds are still relatively new, I had to relax one rule. Instead of insisting that a fund must have a minimum five-year track record to be included, I looked at any F-series fund that has been around at least three years. This left me with 212 funds. From these, I selected the funds with the best returns, the lowest risk and the lowest cost. As usual, I rated funds on the basis of diamonds — one diamond is bad, five diamonds is great—and I insisted that any fund on my Honor Roll had to have a minimum rating of three diamonds for high returns, for low risk, and for low costs. Three diamonds means a fund is in the top 45% of funds for that criterion.

I worked with six categories of funds — Canadian Balanced, Canadian Bonds, Canadian Equity, Canadian Small Cap, Global Equity and U.S. Equity funds. You will notice that the number of Honor Roll funds is larger for certain categories than others, but that’s pure happenstance. It depends on the number of funds in each category that can meet my demanding criteria for returns, risk and cost.

Best of breed lists the winning funds. The list is quite short. Keep in mind, however, that we were selecting our winners from a relatively small universe of funds. That said, many Honour Roll funds from the February list have now begun to offer an F-series version — in fact, there are now about 2,300 F-series funds on the market. Most of those funds were not included in the rankings because they’re still too young to have met my three-year minimum. As a general rule, though, if you like the traditional load-paying version of a fund, you will love its F-series version because it will cost you less.

Click here for a comparison chart of the Honor Roll.