The transformation of the mutual fund industry, with respect to commissions retroceded to sellers/distributors is in progress

Will this change affect the individual investor?

One of the terms used in the jargon of the industry is TOTAL EXPENSE RATIO (or “TER”).

The TER is calculated by adding up all of the annual costs incurred by a mutual fund and dividing this amount net asset value of the fund. The TER has a direct influence on the yield obtained by an investor. If, for example, the gross performance of a fund is 7% per annum, but the TER is 3%, the investor would only receive a yield of around 4%.

Several factors have an impact on the TER. Primarily it is the size of the mutual fund that is significant, since a larger mutual fund can “dilute” the costs incurred. The higher the TER, the more the investor is disadvantaged. For example if the costs incurred by a fund are 1,500,000 and the size of the fund was 100,000,000, the TER would be 1.5%, whereas, if the size of the fund was only 50,000,000, the TER would be 3%.

However, there is an exception in this race to gigantism with respect to the size of mutual funds: when a fund manager is extraordinarily good, since as a consequence of the fund’s good performance generated by the manager there is no need for significant sales promotion (= higher costs). The fund’s performance is published periodically and this will naturally mark it out in comparison to its competitors and thus automatically attract investors.

Without wishing to go through the complete list of the costs incurred by a mutual fund, the cost component which is the most challenging for the existing business model is the commission retroceded by the fund manager to the internal or external wealth manager of the bank with a mandate for discretionary management or the financial advisor who “placed” the mutual fund in the portfolio of their client.

If one assumes that an individual investor is not obligated to pay a subscription fee for the acquisition of a mutual fund, nor any brokerage fee, the only cost which has to be paid is the annual management fee specified in the “Key Investor Information Document” (abbreviated to “KIID” in English or “DICI” in French) which is required to be delivered to the individual investor prior to their purchase of the mutual fund.

Given that a fund manager will charge a fee to the individual investors of 1.50% per annum (payable monthly or daily), the commission retroceded to the wealth manager could amount to 0.60% per annum. This retrocession has created a controversy between the regulator’s desire to see a reduction in conflicts of interests and the professionals in the industry who receive it.

Not because this commission is necessarily unjustified, but because the fund manager is simultaneously performing two functions, often within the same institution: the first is managing the mutual fund in which the client has invested and the second is “indirectly” selling such mutual fund thanks to the sales/distribution/placement agreement (with a retrocession of commissions) that it has concluded with the wealth manager/financial advisor.

The financial industry has a tendency to include the retroceded commission, which is paid to the seller/distributors/wealth manager as part of the “product” (mutual fund/structured product/etc.), which is offered to the client. This system renders opaque the exact determination of the revenues received by the various protagonists in the chain for the creation and sale of the product, as well as the respective roles that they have played.

The law has been changed several times in order to obligate wealth managers/financial advisors in Switzerland to render account to their clients and inform them of the retrocessions that they may receive as an integral part of their revenues. This is in addition to the management fees invoiced within the framework of an investment management mandate (for example 1.00% per annum), unless the clients specifically object to their wealth manager benefiting from this system of retrocession.

In order to reduce these conflicts of interest it would thus suffice for the retroceded commission to no longer be invoiced by the fund manager, which would imply a reduction in the fees the latter would charge to the individual investor, for example from 1.50% to 0.90% per annum. In consequence, the wealth manager/financial advisor, who had previously been remunerated by a retroceded commission of 0.60%, would henceforth increase their management fees by 0.60% (e.g. from 1.00% to 1.60%) to compensate for the loss of income.

This new system of fees would not change the total amount of the fees paid by the client who has granted a management or advisory mandate to a wealth manager, but it has the merit of separating the fees paid for the activity of the selection of investments and personalized investment advice, from the activity of asset management that has been conferred upon the fund manager.

Naturally, this change would affect the business model of the distributor, who would be transformed over time into an investment advisor, remunerated directly by the client. However, it is also conceivable that fund managers would continue to pay retroceded commissions to the distributor in order to ensure that the mutual funds where “on display”, in which case it would suffice for them to fully inform the client of this.

The real winner in such a transformation would be the individual investor who does not wish to receive advice and is seeking simply to transmit subscription or purchase order for new classes of shares in mutual funds with significantly lower annual management costs.

Caveat emptor* : the “do it yourself” individual investor would benefit from such a transformation, unless they fall for an advertising campaigns that sings the praises of a mutual fund whose future performance does not match the expected return.

*A Latin expression meaning: “let the buyer beware”