Cameron Passmore CIM, FMA, FCSI

Portfolio Manager

Benjamin Felix MBA, CFA, CFP

Associate Portfolio Manager
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Spotting subtle conflicts of interest with your financial advisor

July 29, 2016 - 6 comments

In Canada, it is currently up to the investor to ensure that their interests are truly being put first when they are receiving investment advice. Most Canadian financial advisors are held to a suitability standard, rather than a best interest standard – meaning that as long as their advice is suitable, it does not have to be in the best interest of the client. Conflicts of interest are generally subtle, and they are ingrained in the way that many Canadian financial advisors do business. I often hear disbelief when I explain to someone that the advice they have received was likely influenced by an incentive (commission) for the advisor. Financial advisors do not generally have malicious intent, but they are often in a situation where the nature of their compensation puts their interests at odds with the interests of their clients.

A financial advisor licensed to sell mutual funds might receive 1% per year on the investment assets that they manage. However, rather than earn 1% throughout the year, the advisor has the option of generating a 5% up front commission at the time that they invest a new client’s assets, plus 0.5% per year ongoing. This is referred to as a deferred sales charge (DSC) or back end load. The catch for the client is that only funds with high management fees offer the DSC form of compensation for the advisor. Low-cost index funds and ETFs do not offer large DSC commissions for financial advisors. We know, from academic research, that fees have been the best predictor of fund performance through time, but most financial advisors are oblivious to the fact that high fee products are likely to do more harm than good for their clients. Their heads are full of attractive sales pitches and compensation structures from fund companies instead of the academic evidence that should be driving decisions in the client’s best interest. Any time a financial advisor mentions DSC, low load, or back end load, it is a red flag. It means that the advisor is going to earn a large commission, and the client is going to be locked in to a high-fee fund for at least three years.

When receiving investment advice from a financial advisor that is only licensed to sell insurance, the investment vehicle that they are likely to recommend is a segregated fund. Segregated funds are insurance products that are effectively similar to mutual funds, with some insurance features. The insurance features usually include a death benefit guarantee, maturity guarantee, and the ability to assign a beneficiary for the assets on death. To pay for these features, segregated funds tend to have higher fees than mutual funds. The reality is that the features of segregated funds will usually be unable to justify their significantly higher fees. If a financial advisor is recommending segregated funds, it is likely because that is the only thing that they are licensed to sell, even if it may not be the best thing for the client. Any time an advisor is recommending segregated funds, it is important to understand exactly what their reasoning is, and why a mutual fund or ETF is not a better solution. If you ask the butcher what you should have for dinner, they are unlikely to recommend salad.

There are plenty of financial advisors in Canada who are good people with good intentions, and who are trusted by their clients. A significant portion of these financial advisors are in situations where their advice is naturally conflicted due to their compensation structure; they may not even be aware that they are giving conflicted advice. In my experience, the advisors giving conflicted advice have done their own version of due diligence (maybe something like finding funds with good past performance to justify higher fees) in order to rationalize the advice that they are giving, making it even harder for a client with limited investment knowledge to notice that something is not right. By looking out for DSC funds and segregated funds, and asking questions about them when they come up, investors are in a position to spot some of the most common conflicts of interest.

By: Ben Felix with 6 comments.
  18/03/2017 7:35:31 AM
Nice! Thanks for sharing this information.
  01/03/2017 4:05:00 AM
Manuel Moquete
The DSC is a fee that gets charged to a client (5-6% in year 1, declining to 0% in years 6-7) if they sell a mutual fund without transferring it to another mutual fund from the same company.
  27/01/2017 9:43:59 AM
Ben Felix
Selling 0% front-end loaded funds does not remove the conflict of interest. The problem is that funds that pay trailing commissions tend to be actively managed, and tend to have higher fees overall. Low-cost index funds, whether they are mutual funds or ETFs, do not pay trailing commissions. An advisor who has built their business on trailing commissions is unlikely to recommend index funds because they will not earn any compensation. They will not get paid if they recommend index funds. They will get paid if they recommend active funds (whether DSC or front-end). The evidence suggests that index funds are in the best interest of the end client. That is a very clear conflict of interest.
  26/01/2017 1:51:36 PM
Bruce D Loeppky
While most of this information is correct,it does tend to lead readers along a certain path towards a foregone conclusion.DSC funds only account for about 10% of the fund business these day.Many like myself have gone the 0% Front End(FE) route for years to give clients flexibility and make the relationship more a Win-Win.Often EFT's don't have compensation 'built in' so the only way to use them is for an advisor to go F Class and add 1%.The F Class business model has certain drawbacks which is why most financial advisors don't operate under that business model.
The definition of conflicted advice vary's depending on who you talk with so using it can be quite misleading as well.
  30/08/2016 1:41:01 PM
Can you recommend a good advisor in Montreal who has the clients best interest.
  05/08/2016 12:11:16 PM
Frank Tooton
Great article, thanks Ben!

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