Shifting patterns in the load universe

(June 16, 2005) Advisors have been consistently shifting their compensation from deferred service charges or back-end loads since 2002, says a new report by Toronto consultancy Investor Economics. But it’s not just advisors: no-load funds offered primarily by banks and some highly regarded small independents have reached an historic high of 40% of long-term funds, excluding money-market vehicles.

The load universe stands at $242 billion — 5% below its 2000 peak — of which about 33% is in front-end load funds, including zero loads. Investor Economics, in its latest Insight report, attributes this shift to advisor demand. But advisor demand can be fickle. Insight also reports that F-class funds, where the advisor bills the client directly instead of receiving a trailing commission, have received a less-than-enthusiastic take-up.

What’s helping the shift to front-end loads is three years of net redemptions of back-end load or deferred sales charge (DSC) funds. It is a shift, Investor Economics notes, that is largely advisor-driven. Advisors “are opting to sell front-end load funds as a way of ‘annuitizing’ their income streams and maximizing revenues from existing assets,” Insight says. The strategy allows advisors to “‘go fee-based,’ without imposing a separate expense on their clients.”

But this is taking place against a backdrop where assets bought on a deferred-load basis are now maturing. As a result, fund companies, worried that advisors might redeem assets but buy front-end funds at another manufacturer, have inaugurated programs that automatically convert back-end load units to front-end load units. They have also introduced or maintained load option programs even where there is little growth, to keep assets from drifting away.

At the same time, fund companies are also facing pressure on the bottom line: front-end loads are more expensive because they pay double the trailing commission. “Not that profits evaporated,” Investor Economics explains, “but they become eroded from the nearly doubled cost of distribution. This scenario is not feasible for some fund companies.”

Still, DSC funds aren’t dead yet. Younger advisors still use them to build up a book, and some older advisors continue to rely on them because that’s they way they’ve structured their business. However, as advisors turn to a trailer-commission-driven model, and older, DSC advisors retire, front-end charges will likely gain momentum.

Another factor in the mix, however, is consumer behaviour. “For the bigger-ticket investors, the focus is on zero front-end load,” Insight reports. As evidence, it points to the virtual collapse of front-end fees. Where 3% was once common, the current commission range is 0% to 2%, with advisors, fearful of losing clients to competitors, heading to the zero-end of the scale. The competition, Investor Economics says, comes in the form of fee-based and flat-fee brokerage accounts, no transaction fee fund wraps, and, from the banks, no-load funds and fund wraps.

The shift to front-end loads is greatest among full-service brokers, who are also in the forefront of propriety fee-based products, direct competitors to funds.

Investor Economics also suggests that low-load funds — which have a two or three-year redemption schedule — represent the middle ground for many advisors who are still mulling over whether to move to front-end loads. It saves them from having to negotiate loads with clients, while supporting the economic model of a business based on upfront commissions.

Still, although advisors may be going “fee-based,” that has not translated into support for F-class funds, where the trailer amount is stripped out of the management expenses, and charged separately by the advisor. The slow take-up of F-class funds in part reflects the fact that mutual funds have fallen out of favour among in brokerage accounts, where they account for 17% of assets. On the mutual fund dealers’ side, there’s a separate impediment, and that’s that back-office operations may not be able to handle billing a separate fee to a client account.

A further issue, Investor Economics says, is that, while de facto advisors are going fee-based, they have not embraced the unbundling of fees. “Although unbundling fees is economically neutral from a client and advisor perspective,” Insight says that several of the industry people interviewed for the report “suggested that the idea of sending a bill to clients for services rendered remains an unappealing option for many advisors.”

Even with the unbundled commissions, however, some advisors feel that fees are still too high for F-class products.

Filed by Scot Blythe, Advisor.ca, scot.blythe@advisor.rogers.com.

(06/16/05)