Unit trust investing: What are trailer fees and how do they eat into your investment returns?

After one too many plates of char kway teow, you find out that you have borderline high cholesterol and you've been prescribed 20mg of Lipitor a day. Naturally, you follow the doctor's advice to the T because he knows what is best for your health.

But what if Pfizer (the pharmaceutical company that produces Lipitor) pays your doctor a recurring fee so long as you're on the drug? Would you question the doctor's motivation in prescribing Lipitor versus lifestyle changes and a diet of oatmeal?

Fortunately, this is against medical ethical guidelines. Unfortunately, this is how the fund management industry in Singapore operates today - but it's not something that many investors know about.

This dirty BIG secret is called the 'trailer fee.'

How do Trailer Fees work?

When you buy a fund, you may pay your bank or brokerage (the 'distributor') an upfront sales fee. But what is not immediately transparent is that the fund management company pays the distributor a recurring distribution commission, or 'trailer fee.' This fee is paid as long as you hold the fund in your portfolio, and is paid by the fund management company directly to the distributor. This means that you're not able to see this fee directly - you will only see it as a reduction in the net asset value (NAV) of the fund (the 'price' of the fund), rather than as an expense on your bank or brokerage statement.

Mind you, this is on top of any sales charge the distributor has already pocketed for selling you the fund, which in Singapore commonly ranges between 2-5% upfront.

Conflict of interest thrives with Trailer fee arrangement

An advisor should be compensated for giving you unbiased investment advice, and acting in your best interests by recommending the right product for you. This model makes it too easy for an advisor to sell you a fund because it has a higher trailer fee - not because it's necessarily aligned with your best interests but because it has the fattest margins. Trailer fees generally range between 0.5 -1%, and can make up half or more of the fund's total expense ratio.

This seriously eats into your returns. A $100,000 investment in a fund earning 7% per annum (a good return) but with a fee of 1.75% versus 0.75% will deprive you of $152,000 in earnings over 30 years.

There are platforms in Singapore that offer unit trusts with 0% sales charge and 0% platform fees. How do you think they make money? There is no free lunch here - the platforms make a very healthy margin through trailer fees that are coming from your fund's returns.

Unit trusts have been losing the battle in the fight against ETFs and a big part of that is due to the high fees, especially for retail investors. Average retail investors in Singapore cannot access share classes of funds with no trailer fees (and thus lower expense ratios), as they are only available to large institutional investors. The need to pay out sales incentives like trailer fees detracts from the unit trust's performance.

Investing should be simple and accessible, and fees need to be upfront and transparent.

Your financial advisor's incentives should always be aligned with yours, and it's important to know clearly whose pockets your money is lining. Investors who do their own due diligence on fund performance must do so net of all fees including the hidden trailer fees.

In our view, trailer fees aren't doing any favours for the fund management companies either. We are encouraged to find fund management companies like Dimensional Fund Advisors and Vanguard that have done away with trailer fees and have aligned themselves to you, the investors, not the distributors.

For the rest of the industry, it's time for trailer fees to go away, kicking and screaming.