In July of 2016, new requirements came into effect for investment firms to provide new disclosure in the areas of performance and operating expenses. These requirements have commonly been referred to as Client Relationship Model II (“CRM2”) reports. Increased disclosure is a step in the right direction for investors, but for some aspects, the disclosure may not be complete or it may lead to confusion. We hope that this note will provide a clearer understanding of how you can best take advantage of these reports.
The first report is an annual statement of charges and compensation. This report has several categories of fees and ultimately shows the amount that your investment firm derives from your account. This can include a number of fees including direct fees as outlined in your account agreement, and indirect fees such as transaction fees, account fees or trailer fees paid by third parties. What is important to understand is that the amount received by your investment firm may not be the same as the total fees paid by you. If you own any mutual funds or other “investment products” such as an Exchange Traded Funds (ETFs), you are also paying indirect fees in addition to the fees you pay to your investment firm receives.
To explain in greater detail, an investor who owns a mutual fund selected by a financial representative on their behalf would be faced with an annual charge by the mutual fund of about 2.25% (for example). The 2.25% charge comes directly out of the mutual fund, it is not charged directly to the investor. Of the 2.25%, a commission (typically about 1.00%) will be paid to the financial representative who sold the fund. The remaining 1.25% covers expenses incurred by the fund and pays the management fee paid to the professional management company who manages the fund…and of course profit for the company who administers the fund.
Of the fees mentioned in the example above, ONLY the 1.00% commission will show up on your report, thereby grossly understating the amount that you are actually paying in fees! If you own mutual funds, ask your financial representative the total amount you are paying in fees and that should help you more easily determine if more competitive options are available or not. Or if you don’t want to ask your financial representative, just visit our portfolio review page and we’ll be happy to tell you how much you are paying in fees.
ETFs also have an embedded management fee but these fees are significantly lower than those charged on mutual funds. Your Justwealth advisor can provide you with information on the embedded fees in the ETFs used in your portfolio
In conjunction with the charges and compensation report is the annual report on performance. It is important for investors to check performance periodically as it can help you determine if you are “on track” with your financial objectives. An important pre-requisite to know if you are on track or not, is that you should have created a financial plan in the first place! A good financial plan incorporates many assumptions about the future including future market values of assets and investment returns. Both of these variables should be included in the annual report on performance so it is a convenient report that you can use to check on your plan and assess how you are doing.
The guidelines for producing the annual report on performance specifies that a money-weighted rate of return methodology must be used (also referred to as a dollar-weighted rate of return or internal rate of return). This method incorporates the impact of the amount and timing of investments, which is usually at the discretion of the investor. The benefit of this method is that it provides an accurate assessment of the performance of the account. The drawback of this method is that it takes accountability away from the investment professional and puts greater emphasis on the actions of the investor.
Prior to the new reporting guidelines, a time-weighted rate of return methodology was the industry standard. This method attempts to negate the impact of the timing of cash flows into or out of an account so that the investment performance is not affected by investor’s actions and can therefore be attributable to the investment professional only. This method makes comparing performance of different investment managers a more apples-to-apples comparison, but may be less indicative for an individual account.
To provide a sense of how this could cause discrepancies, let’s consider a very unlikely example: An investor invests $1, and then adds $1,000,000 to the investment one year later. In the first year the rate of return on the investment is -10%, in the second year, the return on the investment is +10%. Under a money-weighted rate of return calculation, the return will be closer to +10% since the calculation will be heavily skewed towards the return applicable to the higher amount. In a time-weighted rate of return calculation, however, the return will be closer to 0% since the impact of the amounts are not factored in. In either case the amount in the account at the end of two years is the same, but the accounting of the performance can clearly paint two different pictures.
Clearly, the difference in methodologies may cause some confusion if you compare results using different standards (or using different sources) so read the fine print and ask questions if you are not sure about which method is being used to calculate performance.
Although the Annual Report on performance specific to your account reflects money- or dollar-weighted returns, the Monthly Rate of Return report available to your through your client portal reflects time-weighted rates of return. Performance reflected on Justwealth’s website under the Resources tab, also reflect time-weighted rates of return.
Written by Eric Helmer, Vice-President, Operations at Justwealth.
Updated by Cathy Tuckwell, CFA, – Justwealth Compliance