THE BLOG

What the Mutual Fund Industry Isn't Telling You

11/14/2013 08:28 EST | Updated 01/23/2014 06:58 EST

Are you apathetic when it comes to financial advice? Apparently, if you own mutual funds, you are. At least that's the conclusion of a recent survey conducted by the Investment Funds Institute of Canada (IFIC).

I don't think this is a huge revelation considering we all have different opinions, but what I do find interesting about this particular survey is the way the information was (as result of the questions) presented.

I don't believe the average person has any idea of what an embedded commission is or how it affects them. As a matter of fact, I wouldn't be surprised if most investors of mutual funds had a better understanding of how a black hole works.

The root of this conundrum is that advisors who sell mutual funds usually get paid from the fund companies. The fund companies take money out of the investment fund on a daily basis and send a commission cheque to the advisors' dealer (usually monthly). The dealer, in turn, takes their "cut" and then passes the balance on to the advisor. The commission that the advisor receives is "embedded" in the management cost of the funds.

Another option available to investors is called "direct commissions." This is where the client agrees to pay the advisor a fee directly from their investment account. The commission is paid separately and is identifiable; however, the fund manager still takes their fees out on a daily basis? (which is not identifiable or quantifiable).

One major point of the survey was that currently only 14 per cent of mutual fund clients pay their advisors directly, even though 41 per cent said they would prefer to pay directly. At the same time just over half (51 per cent) said they would prefer to pay their advisor through mutual fund fees (out of sight out of mind).

People preferring to pay advisors through mutual funds is an unfortunate reality in the industry. But what really intrigued me was the survey result that found that 47 per cent of investors would likely ditch their advisor if they had to either: a) pay them directly, or b) pay more than they currently do.

The reason this intrigues me is that the mutual fund industry is convinced that if you get rid of embedded commissions then the cost to investors will go up. Why is that the case? Call me simple but I think that's a ridiculous argument. The real issue here is transparency. The mutual fund industry doesn't want it, mutual fund salespeople don't want it, and most importantly, mutual fund companies don't want it.

I think people are ambivalent when it comes to mutual funds for no other reason than that most people have no idea what the mutual fund industry is and how it works. It's a black hole -- mysterious and unexplainable.

My advice is to either avoid mutual funds altogether, or look for the lowest-cost index funds you can find. Otherwise, like a black hole, you'll find things just have a way of disappearing.