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The Canadian Financial Advisor

Commentary on the CSA's recent status reports (CSA Staff Notice 33-316 & 81-323)

Benjamin Felix

The Canadian Securities Administrators have been reviewing two different, but related issues for over a year now.  Both of the topics receive a significant amount of coverage in the media; they are Mutual Fund Fees and the Appropriateness of Introducing a Statutory Best Interest Duty When Advice is Provided to Retail Clients (making it the law for advisors to act in the best interest of the client).  I just want to express what I feel were the highlights of both of these papers, and offer my commentary.  I have been on three sides of this equation (investor, mutual fund salesperson, and fee based investment advisor), and as such I think that I can offer some unique insights.  The stakeholders in this discussion have been identified as the mutual fund industry, and the investors.  Their points of view are summarized below.

The Mutual Fund Industry

  • There is no evidence of investor harm that warrants a change to the mutual fund fee structure in Canada
  • A ban on embedded compensation will have unintended consequences for retail investors and the fund industry, including:
    • a reduction in access to advice for small retail investors,
    • the elimination of choice in how investors may pay for financial advice, and
    • the creation of an unlevel playing field among competing products and opportunities for regulatory arbitrage; and
  • We should observe and assess the impact of domestic and international reforms before moving ahead with further proposals.

The Investors

  • Embedded advisor compensation causes a misalignment of interests which impacts investor outcomes and should be banned;
  • Investors should at a minimum have the true choice to not pay embedded commissions;
  • We need to implement a best interest duty for advisors; and
  • We need to increase advisor proficiency requirements and regulate the use of titles.

The statement that there is no evidence of investor harm that warrants a change to the mutual fund fee structure is just about the worst reason that I have ever heard to allow a regulatory policy to remain the same.  A practice should not be allowed to continue because no harm has yet been caused by it.  My point here is especially salient when we consider that other countries across the globe are changing their mutual fund compensation structures because they have had problems in this area.  The UK and Australia have prohibited conflicted advisor remuneration "in response to unique consumer protection gaps and situations including mis-selling scandals causing harm to investors, which are not present in Canada."  So despite serious problems with the exact same thing in other countries, we don't need to change it in Canada because nothing has happened yet...seems like a good idea.

I do agree that changes to the regulations could have ramifications beyond the scope of their intentions, but I do not think that these ramifications would be a bad thing.  There is some merit to the statement that unbundled mutual fund fees would reduce access to financial advice for people with small (less than $100K) portfolios.  It would not be beneficial for either the client or a fee for service advisor to enter into a relationship with only a small amount of capital to invest.  As it stands today, small retail investors are in a situation where they are limited in their options beyond investing in mutual funds with high expense ratios if they want financial advice - the only reason that financial advice is affordable with the current embedded commission model is due to the existence of the deferred sales charge (DSC).  The DSC is exactly what it sounds like; instead of paying a bunch of money (5-6% of the account) up front, you pay it behind the scenes over five or six years and never even notice that the advice you received cost anything.  This is a great idea for the advisor as they receive remuneration at the time of the sale.   It also seems to make sense for the investor because they never see the money leave their wallet, until they want to move their account or withdraw their funds before the six years is up.  If the money does not stay invested for the full deferral period, the client is on the hook to pay the fund company back for the money that their advisor received at the time of the sale.  Another issue in this area is that not all mutual funds have the DSC option; in my experience, funds with low fees that do not involve predictive management or large amounts of trading cannot be purchased in this manner.  So... small investors that want advice are likely to have their money invested in expensive funds that allow their advisor to apply the DSC to make it worth their while.  Knowing that information, I'd say that  although small investors can afford advice in the current environment, the advice that they are getting is highly biased towards funds that can be sold with the DSC.

The industry has stated that they do not think that there are conflicts of interest with the embedded fee structure because all types of mutual funds in Canada have comparable trailing commissions.  On this topic, I can speak from direct experience.  When I was operating on the MFDA platform I was very limited in the funds that I was able to offer.  Yes, there were hundreds upon hundreds of mutual funds with high expense ratios claiming to be able to beat the market available to me and the people in my office, but as I started to shift my thinking towards the use of ETFs and index tracking mutual funds I learned that I could not access them.  I remember discovering TD's index funds and being told I shouldn't use them because I couldn't make any money, and I wasn't able to use Dimensional Fund Advisiors because my dealer did not acknowledge them as a supplier.  It is true that most equity mutual funds with high fees have the same trailing commissions, but I would argue that when advisors are limited to using these funds it is difficult to act in the best interest of the client.  Based on my experiences I can safely say that the clients' best interests are not being put first.  Of course, this shouldn't come as a surprise.  In the current regulatory environment investment recommendations only have to be deemed suitable for the advisor to be legally off the hook.

This lack of a requirement to act in the best interests of the client, or lack of a fiduciary standard, is an issue on more than one level.  To open the discussion of the lacking fiduciary standard I first need to explain the educational requirements in place for an advisor to begin operating in this industry.  In order to sell mutual funds, and call yourself an advisor, it takes one exam requiring a 60% to pass and a 90 day supervised training period.  The exam is designed to take between 90 and 140 hours to prepare for.  So with that said, how is someone supposed to know if they are acting in the best interests of their client when they barely know what they are selling? During the 90 day training advisors aren't even trained to put the interests of the client first, they are trained to make suitable investment recommendations. Using the UK as an example, when they prohibited embedded commissions and increased regulations there was a drop in the number of advisors because some of them could not meet the proficiency standards put in place.  To compound this issue, the CSA cited a study stating that most investors already think advisors have a legal duty to act in their best interest.

The fact that there is a debate around whether or not advisors should have a legal duty to act in their clients' best interests is a little bit silly right?  How is this even a question?  The industry argues that the cost of an investment product should not determine suitability; although an advisor may place their client's investments in a more expensive fund they may have done so because the more expensive fund is expected to perform better in the long run...what?  I don't even want to touch that one.  History tells the story of expensive funds outperforming the market better than I can.  The industry also poses that the introduction of a fiduciary standard will give people less incentive to educate themselves on investments and place more reliance on their advisor.  We certainly wouldn't want clients to forgo educating themselves in favour of taking advice from their professional advisor.  I of course say that in jest, but it may hold more truth than it should with proficiency standards at their current level.  

Another argument that the industry poses against implementing a fiduciary standard is that it would be expensive, and these costs would be passed to the client.  To this I say that clients are better off paying more for advice when the advice has their best interests in mind than getting cheap advice that quietly pads the pockets of their advisor.

One of the biggest problems the mutual fund industry would face if a fiduciary standard and unbundled commissions were implemented is that they only sell...mutual funds.  If the most suitable product for a client was not a mutual fund, or like in my experience the most suitable product was a mutual fund without embedded commissions, how can the client's best interests be served?

Personally, I think that the fact that there is a debate around these issues at all is ridiculous.  I worked with some great people when I started in this business on the MFDA platform, but it did not take me long to realize that there were many pieces missing if I was going to be acting in the best interests of my clients.  There a lot of good people in this industry that genuinely think that they are doing what is right for their clients; it is an issue of education on the part of the advisor. I look forward to seeing how all of this turns out, though it doesn't make any difference to me.  I am already operating on a fee-only basis within a firm that has a self imposed fiduciary standard.  

Everyone else will get it right eventually.