Mutual Fund Deferred Sales Charges are Designed to Hide Bad News

Mutual fund investors caught by deferred sales charges (DSCs) understand their downside.  They’d like to sell their funds but face penalties as high as 7% if they sell.  DSCs are set to be banned across Canada (but only restricted in Ontario) in mid-2022.  Until then, mutual fund salespeople masquerading as financial advisors can still sell funds with DSCs to unsuspecting investors.

Before DSCs existed, it was common for advisors who sold mutual funds to get a “front-end load,” which is a fancy term for giving some of an investor’s money to the advisor or the advisor’s employer.  So, an investor might invest $50,000 with an advisor, but the first account statement might show only $47,500.  The missing $2500 was a 5% front-end load offered as an incentive to the advisor to hunt for mutual fund buyers.

Not surprisingly, investors didn’t like to see a big chunk of their savings disappear like this.  Mutual funds had a problem.  They needed to give commissions to advisors so they would sell mutual funds, but investors didn’t like to see some of their money disappear.  The solution to this dilemma came in two steps.

Raising Annual Fees

Mutual funds charge annual fees to investors called the Management Expense Ratio (MER).  MERs are expressed as a percentage of invested assets, and while they seem small, they build up to intolerable levels over decades.  Many mutual fund investors don’t know about MERs and don’t notice their corrosive effects.

One way to cover the cost of advisor commissions is to simply raise a fund’s MER.  This works well when investors stay for the long term.  When investors stay longer than 5 years, a one percentage point  increase in the MER covers a 5% up-front advisor commission.

But what happens when an investor sells out of the fund after less than 5 years?  In this case, the mutual fund can’t recover the advisor commission.  Even, worse, advisors would have an incentive to move investor money frequently from fund to fund to collect more commissions, and investors wouldn’t mind because it wouldn’t cost them anything.

Deferred Sales Charges (DSCs)

Someone had the bright idea to charge investors penalties when they leave a fund too soon.  Today, it’s common for DSC funds to charge investors as much as a 7% penalty for withdrawing their money in the first year.  This penalty typically declines each year until it’s gone after investor money has been in a fund for 7 years.

So, investors end up paying advisor commissions one way or the other.  Either the investor stays in the fund for a long time paying high MERs, or the investor leaves early and pays the deferred sales charge.  Advisors still have an incentive to move investors’ money from fund to fund to generate more commissions (called “churning”), but many investors would notice the hefty DSC charges.

Mutual funds and advisors often tell potential investors that DSCs are an incentive for investors to focus on the long-term, but the truth is that DSCs are a way to pay advisors to sell mutual funds in a way that is invisible to most investors.  This magic trick of hiding hefty advisor commissions gets advisors through the early stages of the relationship with a new client.  Problems don’t appear until the client tries to leave.

It’s not a stretch to say that the introduction of DSCs led to the mutual fund explosion that started around 1990 in Canada.  Once mutual fund fees were pushed further from investors’ view, sales took off.

Conclusion

So, if an advisor is trying to sell you a DSC mutual fund, you’re being asked to accept high annual fees for as long as you own the fund, and if you try to sell early, you’ll get hit with additional fees.  It’s not hard to see why this might not be in your best interests.