At the end of 2016, 11.3% of Canadians’ investment fund assets were invested in index funds and similar passively managed products. Our neighbours in the United States are ahead of us, with 34% of their investment fund assets invested this way. In 2016, Canadians added $10.9 billion to passive funds, and $10 billion to actively managed funds. In the U.S., investors added $490 billion to passive funds, and removed $326 billion from actively managed funds.

The evidence is clear, our neighbours down south are catching on, and Canadians are intelligent people, so what’s going on?

In this episode of Common Sense Investing, I’m going to explore why Canadians have been slow to adopt index funds.

Put yourself into the shoes of an average Canadian getting started with investing. Where do you go?

Well, if you are the average Canadian, you go to your bank. Sounds like common sense, right? Well…let’s see….

Canadian banks don’t generally train and incentivize their financial advisors to sell index funds. They train AND incentivize them to sell their actively managed funds, which have higher fees and are more profitable for the bank. And we know how relentless the banks are in ensuring their profitability. 😉

If you don’t go to the bank, you might look online or ask a friend for an introduction to a financial advisor.

There are plenty of non-bank independent financial advisors in Canada. The compensation model for these advisors has been commission-based for a long time. It’s only very recently that financial firms have started offering and promoting other compensation models. As it stands now, many financial advisors are still paid by commission associated with the high-fee mutual funds that they sell. Index funds do not generally pay commissions.

I’ve talked a little bit about the incentives that might be keep dollars flowing into actively managed funds in Canada. The other important factor is our regulatory environment. In the United States, Registered Investment Advisors have been seeing massive growth, and are currently managing around one quarter of investment assets in the United States.

This specific type of registration requires the advisor to act as a fiduciary, to act in the best interest of their client. This may seem obvious, but Canadian financial advisors do not generally have a fiduciary requirement – they have a suitability requirement.

What does that mean? Well, if an advisor in Canada recommends a high-fee mutual fund that will pay them a large commission, but it is “suitable” based on the client’s situation, the advisor is operating within the law. See how that isn’t ideal?

The suitability standard’s partner in crime has been, until recently, lax requirements on fee and performance disclosure.

Many, if not most, investors have not known how much they are paying in fees or how their investments are doing, and advisors have not been required to explicitly state these figures. New disclosure now requires financial firms to send their clients an annual report disclosing the total fees the client has paid to the firm, and the performance that their investments have delivered.

Between incentives and compensation that heavily favour high-fee actively managed funds, lack of a fiduciary requirement for advisors, and, until recently, lacking fee and performance disclosure rules, it is no wonder than Canadian investors have not been pulling money out of actively managed funds and moving it into index funds at the same pace as our neighbours across the border.

Join me in my next post where I explain why actively managed funds have such a hard time beating the market.