DSC sales bruised but not beaten

(November 2007) Since the beginning of the decade, industry observers have predicted a quick demise of the deferred sales charge option on mutual funds. While DSC may no longer be the load option of choice for advisors in Canada, it refuses to die out.

This stands in stark contrast to the U.S. market, where the DSC had few fans to begin with. Since the end of the tech bubble, B-class shares, the U.S. equivalent of DSC, have undergone a rapid demise.

Sam Campbell, director of research at Boston-based Financial Research Corporation, says at the height of its popularity in 2000, B-class shares accounted for about 12% of the U.S. fund assets. Campbell says that has dwindled to 3.3%; in dollar terms, that’s a decline of tens of billions each year in net outflows, $57 billion last year alone.

“The decline has been pretty substantial,” Campbell says. “It will definitely continue to decline. Net sales in B-class shares were positive going all the way through 2000, since the [DSC] schedule typically sees a conversion to an A-class usually in the eighth year. A B-class is probably sitting at 0% redemption fee for the eighth year and 1% fee in the seventh. Just from conversions alone, there are probably a decent chunk of B-class assets that will be redeemed.”

Campbell says the decline in B shares really got going in 2004 when regulators started to crack down on firms that sold B-class shares to clients ill-suited to the redemption penalty.

“There are still plenty of firms that offer these, and ultimately it’s up to the advisor to figure out what the most appropriate pricing is,” he says. “Just from how their business models are moving towards fee-based as the ideal, and the fiduciary risks and liabilities involved, advisors are not opting for B shares.”

In Canada, the DSC has taken it lumps, says Iassen Tonkovski, a senior analyst with research firm Investor Economics, but it still accounts for more than 50% of the industry’s assets under management.

“At the end of March 2007 — the latest measure we have on this trend — DSC funds represented 55.4% of total load funds, down from 75.1% in Dec 2000,” Tonkovski says. “Front-end funds accounted for 41% of all load assets. An emerging structure is the low load, up to 3.6%, from 1.9% in Dec 2004.

Tonkovski says it’s been no-load funds, favoured by do-it-yourself investors and fee-based advisors, that have seen the greatest growth over the past few years. No-load funds now account for 43.6% of the industry’s assets.

“Fortified by increasing interest among advisors to annuitize their book of business, front-end load is the preferred option for those moving towards a business model more reliant on fees than transaction commissions,” Tonkovski says. “Competitive pressures also play their part in the shift towards front-end. In an environment characterized by intense competition for share of a client’s investment wallet, advisors find little, if any, opportunity to offer funds with long periods of virtual lock-in.”

Sales of DSC-option funds have dropped dramatically in the past seven years; however, the rate of decline has slowed — a trend that has not gone unnoticed by fund companies.

At Fidelity Investments Canada, after a steep decline, DSC sales are relatively flat, says Phil McDowell, senior vice-president of finance and chief financial officer for Fidelity Canada.

“Over the long term, we have seen a decrease. That trend has actually abated,” McDowell says. “DSC sales account for about 45% of gross sales and they’ve held pretty steady over the last three years.”

McDowell says Fidelity saw redemptions stemmed when the company introduced a new fee structure on its DSC funds in 2005.

“With our DSC funds, once the assets come off the schedule, we automatically convert it to our initial sales price fee,” he says. “ISC has a lower management expense. Investors end up paying a lower management fee after seven years. We’re basically rewarding our clients with a lower fee at the end of a DSC schedule.”

The result, McDowell says, is Fidelity is likely picking up a larger market share of DSC sales than it has in the past. This has led to a reduction in its ISC sales. There has been a substantial uptake in its low-load sales, which are sort of a compromise between the two load structures and offer a smaller redemption fee and shorter schedule than DSC. Low-load sales account for about 36% of Fidelity’s gross sales.

McDowell says it’s important that the DSC remain an option for investors, particularly smaller investors, who would see a chunk of their assets lopped off their principal investment if they paid an up-front fee.

“DSC allows smaller investors to have access to advisors,” he says. “Generally, I believe investors are using these types of load structures with smaller investments because it’s economical for the advisor.”

One area where DSC remains the dominant fee structure is in segregated funds.

For instance, CI Financial reports that five years ago, the DSC option accounted for more than 50% of its new mutual fund sales; it now accounts for less than 25%. However, two-thirds of its new sales on its partnered seg funds with Sun Life and Transamerica are in DSC. Popular seg fund products like Manulife’s Income Plus also use DSC.

Since most seg fund contracts are in excess of seven years, investors are less likely to be deterred by the redemption penalty.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(11/01/07)