Big changes for mutual fund investors

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graham-bodelBy Graham Bodel, CFA, Chalten Advisors

Special to the Financial Independence Hub

Transparency, education and competition should drive better outcomes for investors.

Recent enhancements put in place by the Canadian Securities Administrators (CSA) have sought to better align the interests of investors and the investment industry that serves them.

Initiatives like the Customer Relationship Model (CRM) are designed to increase transparency and help investors make more informed decisions about the kind of advisor with whom they work and the type of products in which they invest.  The idea is that with full disclosure, investors will be armed with the right information to make better decisions and protect themselves from bad products and sales practices.

Banning fund trailer commissions

So, we were somewhat surprised by last week’s announcement by the CSA that indicates they will be moving ahead, subject to consultation with investors and the industry, with banning embedded trailing commissions on mutual fund sales.  It seems even the regulators have lost faith in transparency to properly do the job of protecting investors.  This represents a significant next step in a progression of possible measures, one that regulators in countries like the UK and Australia have already taken.

Let’s dig into the reasons why regulators might be concerned.   Mutual fund fees in Canada are among the highest in the developed world.  This is partly because a portion of the management expense ratio (MER) on many mutual funds is a commission paid to the person or institution selling those mutual funds.  This embedded “trailing” payment is paid not just as an upfront sales commission but every single year that the investor owns the fund, supposedly to compensate the sales person or advisor for the ongoing service they provide.  The catch is that it’s paid no matter what and many people aren’t even aware that any commissions are being paid.

Why some funds are suggested over others

To be clear, the thing that irks the regulator is not that advisors are getting paid for what they do.  The concern is more the embedded/hidden nature of the commissions and the incentives that influence advisors to recommend certain products over others.  For example, a mutual fund with a 2.5% expense ratio (yes, high but not uncommon) might typically pay a trailing commission of 1% per year to the mutual fund salesman.  Now if there were a lower cost mutual fund or other solution that might be better for the end investor but didn’t pay a commission, what do you think the mutual fund salesperson would recommend?

Without the trailing commission, there is no incentive for the salesperson to recommend the fund because commissions are how he or she gets paid.  Remove the incentive, or lack thereof, and you free the advisor/salesperson to recommended either fund.  With a direct compensation model advisors could be paid the same but would have the freedom to recommend a wider variety of products.  Now there might be a little more scrutiny placed on what that advisor actually does for his or her 1% if it’s not embedded in the overall expense ratio, but that scrutiny would also be better for the end investor.

So what is the likely outcome?  We suspect that payments to advisors probably won’t change that much, at least the ones that can justify their compensation with good service.  It’s therefore not the 1% of the 2.5% expense ratio that will be under threat.  It’s the other 1.5% that goes to the fund manager that will come under pressure.

More incentive to recommend costly active funds

Usually it’s actively managed funds that have high expense ratios like 1.5% before commissions are added.  Passive index funds and exchange traded funds tend to have much lower expense ratios than active funds, some as low as 1/20th of 1%.  The evidence is very compelling – after fees are taken into account, the vast majority of active funds underperform passive index funds, especially over longer periods of time.  However passive index funds and ETFs rarely pay trailing commissions so there’s no incentive for commission-based advisors to offer them to their clients.

If incentives are changed so advisors are free to offer a broader range of solutions, we suspect the expensive, underperforming active funds will come under much greater threat.  This is exactly what has been happening in the US as companies like Vanguard who offer very low cost passive index mutual funds and ETFs continue to take assets away from the big actively-managed mutual fund complexes.  The trend hasn’t been the same in Canada but this new regulation could lead to massive changes, a tipping point if you will.

In the past we’ve written about this issue and have always hoped that competition driven by transparency and investor education would lead to a better result for Canadian investors.  The regulators have clearly come to the conclusion that banning certain sales practices will have a better chance of success or will get us there faster.  Maybe they’re right.  Forcing change will likely bring near term disruption to the industry and investors, and that is why the CSA is engaging in extensive consultation before they consider any specific rule changes.   Hopefully all parties will be in a better place after things shake out.

Who knows, maybe a few years from now we won’t feel the need to have “Fee-Only” as part of our name.

Graham Bodel is the founder and director of a new fee-only financial planning and portfolio management firm based in Vancouver, BC., Chalten Fee-Only Advisors Ltd. This blog is republished with permission: the original can be found on Bodel’s blog here.

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