What it means
When you buy a mutual fund through an adviser, the fund company charges a management fee for running the fund. A portion of that fee, typically a fraction of a per cent of your holding each year, is passed on to the firm that sold the fund.
It is called a trailer because it trails along behind the original sale for as long as you stay invested. The idea is that the adviser provides continuing help, such as reviewing your plan, rebalancing and answering questions.
In practice, the fee is paid regardless of how much service you receive, which has drawn criticism. Because the fee is embedded in the fund, the investor does not receive a separate invoice.
The cost compounds over time. A trailer fee reduces the return you receive each year, and over decades the effect can be large.
A difference of 0.5% a year on a growing portfolio adds up to a meaningful sum. There is also a conflict of interest.
An adviser paid by trailers may be tempted to favour funds with higher payments, and may have little incentive to suggest lower-cost alternatives. For this reason, regulators in several countries have restricted or banned such embedded payments for some types of advice and moved toward clear, separate fees.
Where trailers still exist, the rules often require disclosure. Investors should ask what the adviser is paid, what services are included and whether a cheaper share class without a trailer is available.
Comparing the total cost of ownership, which includes the management fee, trailer, tax and any advice fee, gives a fuller picture. Businesses that offer group retirement plans or manage staff investments should also examine how advisers are paid.
Trailers may be included in the fund costs in ways that reduce employee outcomes, so transparency is worth asking for.
In practice
Real-world examples.
Example
A client holds a balanced fund through an adviser and pays a total fund cost of 2.0% a year, of which 0.5% goes to the adviser as a trailer. When she asks for a breakdown, she learns that on her $200,000 holding the fund company pays about $1,000 a year to the adviser. She decides to compare other options.
Example
An adviser who now charges a separate annual fee of 0.75% moves clients to a fund class without a trailer. Fund costs fall, and the client sees the advice fee on the statement. The total is similar, but the cost is clearer.
Example
A company reviewing its staff pension plan finds that the default funds pay trailers to an outside adviser. The trustees ask for the share class without the trailer and negotiate a flat fee instead. The change saves members about 0.4% a year.
Formula
Calculation
Annual trailer fee = average fund balance x trailer rate
Suppose an investor holds $200,000 in a fund that pays a 0.50% trailer to the adviser. Annual trailer fee = 200,000 x 0.0050 = $1,000. Over 10 years, if the balance averages $260,000, the total trailer paid is 260,000 x 0.0050 x 10 = $13,000. This amount does not appear as a separate charge, because it is taken from the fund's management fee.Case study
Seen in the real world.
Willowbend Advisory is a fictional firm used for illustration. Most of its clients held funds that paid trailers of 0.5% to 1.0%, and the firm received about $380,000 a year in total. A new regulation required it to disclose these payments to each client in dollars.
Several clients asked what they were getting for the fees. In this illustrative story, the firm moved to an openly stated advice fee of 0.8% and offered lower-cost fund classes, which reduced its income slightly but kept most clients. The lesson is that transparency about pay can strengthen trust.
Watch out
Common mistakes.
- Assuming advice is free because there is no invoice. The trailer is paid from your investment returns.
- Believing a bigger trailer means better service. The fee is set by the fund company and bears no necessary relation to the quality of advice.
- Ignoring the effect over time. A small percentage each year adds up, particularly as the portfolio grows.
Questions
People also ask.
Are trailer fees legal?
They are allowed in some countries with disclosure rules and restricted or banned in others for certain types of advice, so check local regulation.
How can I find out if I pay a trailer?
Ask your adviser, read the fund's prospectus and fee disclosure documents, and look for your annual cost report.
What is the alternative to a trailer?
A separate, clearly stated advice fee, or a fund class that does not pay a trailer, allows you to see and negotiate what you pay.
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