Increased use of ETFs may be increasing the cost of advisor advice

Exchange Traded Funds (ETFs) are supposed to reduce the cost clients pay for investment management. However, in some cases, I’ve noticed that they are actually increasing it. 

Start-up and growth of ETFs

ETFs have been around for longer than you might think – in Canada, 27 years. The first one launched in 1990. It was called TIPS –Toronto Index Participation Shares. 

Fast-forward 27 years. According to the Canadian ETF association (CETFA), we now have 644 ETFs available for Canadians to purchase. That number grows almost daily.

As you are likely aware, the primary advantage of ETFs is their low cost. A well-diversified ETF portfolio can have fees of 0.25% or less per year. That’s only one-tenth of the 2.5% figure that we hear is the average cost of a mutual fund. 

The explosion in the number of ETFs is a fairly recent phenomenon. That growth is not surprising, responding to consumers’ desire for a lower-cost way to invest. As well, there is an increasing groundswell among investors, particularly younger ones, to look for better value for the fees they are paying. 

The good news and the bad news

Now, let me explain why I think that, in some cases, the cost of advice is increasing, while the costs of investment products are decreasing.

I’ll start with a conversation I had with a rep from an investment firm a couple of years ago. His firm offered a quality product, in the form of a mutual fund, with a cost structure much lower than is typical. Well under 0.50%. 

He encouraged me to incorporate the product into my client portfolios. Not just because it had merit as an investment, but because it would allow me to charge more for my wealth management services without raising eyebrows. He suggested that our wealth management fees were too low; I could use his product and pocket the difference. 

I know our full-service wealth management fees are lower than average. I’m comfortable with it. My business philosophy is one of partnership. I don’t feel compelled to generate the maximum possible revenue that the market will bear, I’m playing the long game. 

I want us to deliver outstanding value so that our clients will see us as their financial and life management partners on a multi-generational basis. Of course we need to be profitable; our clients want us to be there for them for the long term. However, we want our clients to meet their financial goals, and so cost matters. That is the balance we aim to strike.

Back to my meet with the product salesperson. The lightbulb went off during our conversation. I thought: “This is the sales proposition?” Buy his product, because it will allow me to charge more?

Guess what? He’s not the only one 

I’m starting to see this trend more often as I review the portfolios of new clients. I’ll explain what’s happening, but first, a brush-up on how mutual fund pricing works. 

Let’s assume that the mutual fund you own has a Management Expense Ratio of 2.5%. Depending on how you purchased that fund (front-end, or deferred sales charge): 

• A portion of that fee is directed to the investment dealer as compensation for their advice. That is called the trailer fee, and it is generally between 0.50% and 1%. 
• The mutual fund company keeps the rest. (There’s HST in there so the government gets some too).

Back to the ugly trend

What some advisors seem to be doing is saying: “Mr. / Ms. Client-or-Prospect), I can reduce your fees from 2.5% to 1.75%. Wouldn’t that be a vast improvement?” 

It might be … but … how do they plan to do that? 

By building portfolios exclusively with low cost ETFs and eliminating the active management aspect of the portfolio! If the ETFs on balance cost 0.25%, and the total cost to the client is 1.75%, then you can see that the advisor component of the overall fee is 1.5%.

Yes, the investor is saving dollars. Actual fees have been reduced by 30%. But the advisor has increased their fees by up to 300%. The question the investor should ask themselves is: “Am I getting more value for my advisor’s increased fees?”

If the advisor was being paid 1% before using full-fee mutual funds, why isn’t that level of fee appropriate now? If it is, then the total cost to the client should be 1.25%, not 1.75%. Reducing cost from 2.5% to 1.25% is what I consider meaningful fee savings. In this case the client gets the full benefit of the lower-cost product. 

Cost of active vs passive fees – not as different as you might think

The cost difference between a low-cost ETF and an actively-managed mutual fund is not as wide as you might think. As I mentioned already, we are looking at about: 

• For an ETF portfolio: 0.25%, on average 
• For an actively managed fund: from 0.75% to 1.00%. 

That’s a difference of ½ – ¾ of a percent for professionally active management versus a passive ETF. 

Just to make everything more complex, many of the newest ETFs are looking more like mutual funds in terms of their structure and pricing. Just because an investment is called an ETF doesn’t mean it is automatically low-cost. Watch out for this one!

So what is it that makes some mutual funds expensive?

It’s the cost of advice and wealth management, over and above product cost. It’s the fee that the person who chose this vehicle for you is being given, for their advice. 

Historically, the cost of advice has been embedded in the management expense ratio (MER) of the fund. That cost is now being reported on year-end investment statements so that investors know what they are actually paying for professional advice.

So, if you eliminate the advice? You’ll reduce your costs dramatically. 

And if you want advice but aren’t getting sufficient value for the fees you pay? Find a new advisor.

Moral of the story

The next time you’re presented with a strategy and a pricing model that says “It’s a lot less expensive than a mutual fund,” get the advisor to break down the fees. Find out how much is product cost, how much advisory. 

You shouldn’t be paying any more than 1% for the advice piece. And for large portfolios, even less.