Financial Literacy Month: Fees are an Important Consideration

Less than 36% of Canadians knew the right answer to basic questions around investment costs.

Ian Tam, CFA 23 November, 2022 | 1:32AM
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The Ontario Securities Commission Investor Office recently commissioned a study to understand the financial literacy of Canadians. In a questionnaire to Canadians, a series of 27 multiple choice questions were asked. On average, investors answered just over half (53%) of the questions correctly. In this weekly Series, we answer some of the questions, and explain why they’re important.

Question: Advisors and dealers can get paid indirectly so it is possible that you can get advice without it costing you anything.

Answer: False (Only 22% of respondents got this right)

In Canada, mutual funds are sold in three ways. Two of them include advice, but in neither case is the advice free.

  1. Commission-based share classes of mutual funds (similar terms you’ll hear include trailer fees, sales charges, front-end load, and back-end load). Some of these funds might charge you a flat fee up front to buy the fund (known as a sales charge or a front load), though this is becoming less common. Regardless of whether you pay this fee, all commission-based mutual funds charge an ongoing MER which is deducted from your assets each year. Make no mistake, even if you don’t pay for advice directly, it still comes out of your pocket. As it is an annual ongoing charge, it is important that you speak with your advisor appropriately to ensure you are receiving advice.
  2. Fee-based share classes of mutual funds (similar terms include: F-class, unbundled, discretionary) are sold through fee-based advisors. Also referred to as a ‘clean’ share class, the MERs charged here exclude the cost of advice, and hence will appear much lower. However, the investor still pays for advice through an overall management fee charged by the advisor directly, and may be based on the assets you have invested. Fee-based advisors in Canada typically deal with clients with larger investment portfolios.
  3. Do-It-Yourself share classes of mutual funds (similar terms include DIY, or Discount, D-class) are sold exclusively through discount brokerages, where no advice is provided. MERs here will be competitive with fee-based share classes, however you receive no advice.  

Question: What is the main advantage that index funds have when compared to actively managed funds?

Answer: Index funds generally have lower fees and expenses (31% of respondents answered this correctly, 46% didn’t know).

An index fund differs from an actively managed fund because the processes behind picking and choosing stocks or bonds are largely automated with little discretion given to whomever is managing the fund. Here, the decisions to buy/sell a security within the fund is pre-determined by the provider of the index, who has written rulebooks and methodologies on how the index is re-balanced (typically quarterly). It would therefore be intuitive that index funds might cost the investor less in terms of fees. Because fees are a consistent detractor to performance, investing in a low-cost ETF is certainly an advantage, particularly in very efficient markets where active managers might have a tough time beating their benchmark index.  We write extensively about this topic in the Morningstar Active/Passive Barometer.  

Question: Individual stocks, mutual funds and exchange traded funds (ETFs) all have management fees (also known as MERs) that reduce investors’ returns.

Answer: False (Only 23% of respondents got this right)
Perhaps respondents were tripped up based on wording of the question since the sentence blended all 3 investments together. Stocks do not carry management fees, but they can come with trading costs. In decades past, these trading costs might have made it prohibitive for very small investors to trade stocks directly. However, with the rise of discount brokerages in Canada, everyday investors can buy/sell stocks either without paying commissions, or with minimal commissions (ex. $5.99 per trade, etc) depending on the broker. A happy evolution for Canadians. Coupled with a low-cost passive asset allocation (aka balanced or ‘all-in-one’) ETF, the combo is truly a formidable budget conscious yet effective way to get invested in a very diversified way with essentially no minimum investment and very low investment costs. 

Unlike owning a stock, owning a mutual fund or an ETF requires ongoing payment for the services of the portfolio manager, and in many cases the cost of advice that an advisor provides. Remember, mutual funds and ETFs charge an annual fee regardless of performance. A fund that gained 8% a year in investment returns but charges 2% as a fee only leaves the investor with 6% return. Guess what happens when that same funds loses 10% a year in investment returns? That’s right, the investor loses 12%. Compounded over time, a 2% fee is substantial.

What Should You Do?

It is disheartening to learn of Canadians’ lack of knowledge around investment costs in Canada, a country where most mutual fund assets continue to sit in bundled/commission-based share classes. Though ETFs are rapidly increasing in popularity, it’s very likely that investors who seek financial advice will be steered in the direction of the traditional mutual fund, which often includes the cost of advice.

Morningstar believes that there is indeed great value to receiving good advice. In fact, we’ve even quantified it through a factor we’ve named Gamma. Through coaching and touchpoints with a good advisor, investors are less likely to get spooked by market volatility and remain invested over the long term. Hence, it is important that Canadians who choose to seek advice receive it on an ongoing basis.  

This article does not constitute financial advice. Investors are always urged to conduct their own research before buying/selling any security.



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About Author

Ian Tam, CFA  Investment Specialist at Morningstar Canada. 


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