Morningstar - Q1 2020 - 21

year, declining gradually to 0% after seven years.
At the time, it was touted as an alternative to
up-front commissions, which could be as high as
9%. But times have changed. Now, front-endloads are now generally set at zero, with dealers
instead being compensated with trailer
commissions of 1% a year.
Morningstar's database shows that 1,625
of 24,000 Canadian mutual funds give the option
of a deferred sales charge. Net assets on these
funds total $117 billion, less than 10%
relative to the $1.6 trillion of assets invested
in all mutual funds.
Although the use of deferred sales charges is low
among Canadian fund dealers, they have caused
much controversy, most notably because investors
can experience eye-watering charges when
they do sell before the redemption-fee schedule.
Here's a grim hypothetical scenario: An investor
walks into a retail bank branch to invest in a
mutual fund. After going through a few options,
she purchases units in a fund that does not require
any up-front commissions to the advisor but
instead contains a deferred sales charge. A year
later, she sells her position in the fund and is
charged 5% of her assets for selling her fund too
early. Yikes.
The argument in favor of DSCs is that they
dissuade investors from having a shortterm approach to investments by penalizing those
who redeem their units at an inopportune
time-and this, in turn, could help stem
market volatility. The fund industry's trade body,
the Investment Funds Institute of Canada,
also argues that such commission structures
allow smaller investors to gain access
to investments that would otherwise not be
available to them.
We disagree. Morningstar's stance on fees
continues to be that they are subtractive to an
investor's long-term success, and deferred sales
charges are an extreme example of this.
Even if a fund performs poorly or no longer meets
their needs, investors may be deterred from
redeeming by a DSC. There's also the temptation

on the part of unethical dealers to churn
accounts by switching the investor to another fund
once the redemption-fee period expires-
because fund companies pay advisors more up
front to sell funds with DSCs.

Nick Train is known for his buy-and-hold approach
to investing-running a concentrated portfolio
of names he has strong conviction in, just
23 holdings at last count. The manager recently
bought his first new U.K. stock in nine years.

If you are already invested in a fund with a
deferred sales charge option, have a look
at the redemption schedule on the fund fact sheet,
which is publicly available on the fund provider's
website. If you are keen on exiting the position,
you may be able to switch to another fund
within the same fund family without incurring the
redemption fee or sell a percentage of your
position without incurring fees.

But as the fund's assets grow, so does the stake
the manager has in each of his few portfolio
names. Lindsell Train is the largest shareholder in
RELX RELX, for example, with a 1.82% stake
in the firm-it is the largest holding in the portfolio,
accounting for 10.2% of assets.

Ian Tam is director of investment research, Canada
with Morningstar.

Capacity Concerns Hit
High-Profile Manager
GREATER EUROPE

United Kingdom

Morningstar analysts have downgraded Nick
Train's Lindsell Train UK Equity fund amid concerns
about how rapidly the fund's assets have
grown. Previously Gold rated, the GBX 9.5 billion
fund has been downgraded to a Morningstar
Analyst Rating of Bronze.
Morningstar analyst Peter Brunt says there are
concerns about how the fund manager is
controlling the capacity of the fund and whether
the strategy will be able to cope as it continues
to grow.
The manager's GBX 923 million Finsbury Growth &
Income Trust has also been downgraded, from
a Gold to Silver Morningstar Analyst Rating. While
investment trusts do not face the same liquidity
issues as open-end funds, as they are not forced to
sell their assets to meet investor redemptions,
analysts are concerned that the growing size
of the trust restricts its investment universe, which
could hamper performance in the future.

The highly concentrated approach also makes the
fund vulnerable to any change in fortunes in
the companies it owns. Also among the fund's
largest holdings are London Stock Exchange Group
LSE:GB, accounting for 10.1% of assets,
Diageo DEO and Unilever UL, with 9.8% of assets
invested in each, and Mondelez MDLZ at 8.7%.
The fund is also concentrated in terms of the
sectors it invests in, with Train a big fan of
consumer companies, where he believes strong
brands and a loyal customer base can
generate returns. Indeed, 38% of the portfolio is
invested in consumer companies and 29% in
financials. The Finsbury Growth & Income portfolio
is very similar, with the same top five holdings
as its open-end counterpart and 40% of assets
in consumer companies.
Brunt says: "The crux of Nick Train's investment
philosophy lies in the belief that a highly
concentrated portfolio of high-quality, cashgenerative, strong and easily understood
business franchises will outperform the market
and reduce volatility over the long term."
The manager's approach has yielded excellent
results-the fund has delivered annualized returns
of 15.6% over 10 years through late December.
But such success has attracted hordes of investors.
As a fund grows, its ability to react nimbly to
market events lessens. So does its ability to invest
significantly in companies further down the
market-cap spectrum.
Brunt adds: "While this has not had a large impact
of performance so far, allowing assets to continue
to grow will only further restrict Train's potential

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Morningstar - Q1 2020

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