Imagine that your hairdresser, instead of being paid by you directly, was paid by the hairspray company… How much junk do you think you’d have in your hair by the time you walked out of there? I’m very happy to pay my barber each time I go, and know that I’ll get the haircut that I want!

The investment industry regulators aren’t willing to stand up and require the same for your relationship with your financial advisor. That’s a problem.

I’ve linked to every paper mentioned in the description below, so take a look and let me know what you think about this.

It’s been 6 years since the Canadian Securities Administrators (the CSA) published a discussion paper asking for comments on the fee structure of mutual funds in Canada1. Several papers researching the topic have come out since then2, clearly demonstrating that funds with embedded commissions bias advisor’s decisions in a way that is not in clients’ best interest.

What Are Commissions?

First, let me define what embedded commissions are and how they work. Embedded commissions are paid by fund companies to advisors, ostensibly for the advice that advisors are providing to their clients. In reality, these commissions are simply incentives for advisors to sell.

A trailing commission is an annual payment stream paid to an advisor by a mutual fund company, as a percentage of the client’s holding in the fund, typically about 1%. A front-end load is an up-front commission paid to the advisor on the sale of a fund to a client, again as a percentage of the value sold to the client. These go as high as 5% of the value of the fund sold. A deferred sales charge is a penalty charged to the client for selling a mutual fund within 5 or 7 years of having purchased it. The penalty is a percentage of the value held in the fund, and typically declines linearly over the years. This penalty helps the fund company recover the front-end load they paid out to the advisor if the client hasn’t held the fund long enough for the company to make it back in annual management fees.

So what has the research shown about the impact of these types of compensation for advisors? Here are some of the damning conclusions:

  • Funds that pay trailing commissions underperform.
  • Advisors push investors into riskier funds, as a result of the varying levels of trailing commissions.
  • Advisor recommendations are biased towards funds that generate more commission for the advisor.

The rest of the world already knows this, which is why the UK and Australia have banned these types of advisor compensation. Advisors there have to discuss their fees openly with their clients, and clearly explain their value proposition in exchange for the price they are charging.

Changes in Canada

In June, the CSA FINALLY released a set of proposals to address these issues3…and they dropped the ball. The most recent proposals they made call for

  1. Enhanced disclosure of conflicts of interest between advisors and their clients. This will only mean more small print.
  2. Prohibition of all forms of deferred sales charges. Great, but not nearly enough! What about trailer fees?
  3. Prohibition of trailer fees… but only in discount brokerage accounts. If they don’t regulate this one, the courts will force them to. There is a class action suit in progress right now over this issue.

All in all, these proposals fall far short of an outright ban on embedded compensation arrangements. What takes so long for the Canadian regulatory system to see the writing on the wall? 6 years and this is the best they can come up with?

The unfortunate reality lies somewhere in the vested interest that the industry has for maintaining the status quo. According to Strategic Insight, about half of the $1.5 Trillion dollars in mutual funds are sold with some form of embedded compensation. An outright ban will have a huge effect on the industry.

Last time I checked, regulations are meant to protect individuals, not the industry. I only hope that our regulators come to understand this and do what’s right.

 

1 http://www.osc.gov.on.ca/documents/en/Securities-Category8/csa_2012123_81-407_rfc-mutual-fund-fees.pdf

2 http://www.osc.gov.on.ca/documents/en/Securities-Category5/rp_20151022_81-407_dissection-mutual-fund-fees.pdf

3 http://www.osc.gov.on.ca/documents/en/Securities-Category8/csa_20180621_81-330-status-report.pdf

http://www.osc.gov.on.ca/documents/en/Securities-Category8/rp_20150611_81-407_mutual-fund-fee-research.pdf