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This article appears in the October 2021 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

With know-your-product (KYP) reforms coming into effect at year’s end, firms and advisors are well on their way to updating their related policies and documentation processes.

The changes are part of the larger client-focused reforms (CFRs) that come into effect on Dec. 31, and include enhanced know-your-client and suitability obligations. The reforms work together to better align registrants’ interests with those of clients.

The KYP reforms require that firms formally assess and approve products, monitor those products for “significant” changes and provide advisors with KYP training. Advisors must demonstrate KYP proficiency, such as by assessing cost, and consider a “reasonable range” of approved products before making a recommendation. Increased documentation requirements are also part of the reforms.

The new rules aren’t prescriptive. Firms and their professionals are “best positioned to determine what’s useful in evaluating a product,” said Richard Roskies, senior legal counsel at AUM Law in Toronto.

For example, “significant change” isn’t defined in the CFRs but is instead based on professional judgment. Roskies suggested the starting point is to consider material changes — generally, those that move the market. “I would be thinking about creating proactive alerts for any news stories related to the issuer (including earnings calls),” he wrote in a blog post earlier this year.

Whatever the factors registrants decide to include in their due diligence, those factors should be built into their policies, Roskies told Advisor’s Edge: “That way, it’s not haphazard.”

He further suggested that firms standardize KYP as they support their processes with documentation. For example, he’s working with firms as they consider templates to assess different categories of securities, such as a large-cap stock versus a private, less transparent and more complicated investment. The latter would require “a more in-depth review,” he said.

Standardized KYP also enables more consistent due diligence from advisors as they choose the most suitable investment among a reasonable range of alternatives — which means only the firm’s approved products, Roskies said.

Richard Rizi, senior director of investment services with Worldsource Wealth Management in Markham, Ont., said the KYP requirements for advisors are “about practice management.” Regulators “want to make sure advisors have a process and that they’ve adopted that process into their practice” to assess and compare securities, and make recommendations in clients’ best interests.

“Comprehensive and inclusive notes” should accompany recommendations, Worldsource said in a white paper. According to the reforms’ companion policy, advisors should document their key assumptions, scope of data and analysis as to why a fund is more suitable than another.

Worldsource has defined a “reasonable range” to be four or five products in a given category. “The important thing with the comparison is it needs to be fair,” Rizi said. That means comparing within the same category, such as Canadian equity, and including third-party funds, he said.

Brent Allen, head of strategy and business operations with IG Wealth Management (IGWM) in London, Ont., said advisors at his firm have increasingly moved to managed solutions to allow them more time for financial planning, which will reduce the impact of the KYP changes.

Janine Guenther, president of Dixon Mitchell Investment Counsel in Vancouver, which offers four discretionary portfolios, said the firm is conducting and documenting more stress testing to its portfolios. The CFRs require firms to make information available to advisors about approved products. For model portfolios, the reforms’ companion policy suggests advisors learn about products’ features and risks, and for whom the portfolios are suitable.

“We have to go a little further in making sure individual advisors know more about what’s happening under the hood,” Guenther said. To do that, the firm has made its portfolio update meetings more formal by recording them and ensuring advisors attend.

Edward Jones is launching a KYP hub in October. Advisors can access the website to review the firm’s criteria for products so that “they know what we know,” said Scott Sullivan, principal, Canadian products, with Edward Jones in Toronto.

Considering costs, transfers in

The KYP reforms require that firms and advisors consider, among other things, initial and ongoing product costs.

If advisors don’t consider net return when making a recommendation, Roskies said, “from a regulator’s perspective, they’re not looking at the metric holistically.”

Firms are aiming to keep prices competitive. Edward Jones will have a maximum product cost, Sullivan said. And IGWM has committed to maintaining average or below-average fees for its proprietary funds (as well as advice), based on industry data, Allen said.

Still, cheapest isn’t necessarily best, Sullivan said: “It’s a factor to be considered.”

During a webinar on the CFRs hosted by Morningstar earlier this year, John O’Donnell, compliance manager with the Mutual Fund Dealers Association of Canada, said cost was a “big factor” when comparing products and that advisors must reasonably explain why they choose one product over another. “If you can do that, I don’t think cost is 100% what you’re looking for,” he said.

Firms should also establish suitability policies for transfers in from a client, Roskies said. Advisors need to assess how transfers fit with the client’s overall investment plan and whether the client expects the advisor to monitor the assets. A suitability process is also required, he said.

At IGWM, certain transfers aren’t allowed, such as leveraged ETFs or penny stocks. “We don’t believe they’re aligned to clients’ outcomes and long-term goals,” Allen said.

Establishing a policy for transfers in was top of mind for Guenther, especially since the firm does tax planning and has a small, tailored shelf — and a tax-efficient transfer could mean holding products not on the shelf for an extended period. The reforms’ companion policy says registrants must take “reasonable steps” to understand transferred-in securities within a “reasonable time.”

“We might have to do some extra research” to recommend that the client keep those holdings, Guenther said. The result could be a temporarily expanded shelf, she added.

Product envy?

As compliance requirements increase, the industry has been concerned about narrowing product shelves focused on proprietary products.

CIBC and TD have removed access to new purchases of third-party products for advisors at the branch-advice level, and RBC will do so as of Dec. 31, Investment Executive reported in August. At TD, the change resulted in a 15% reduction in its shelf.

Allen said IGWM advisors won’t see smaller shelves, and he noted expanded sub-advisory partnerships and the move to a nominee platform to accommodate transfers.

Sullivan doesn’t expect the shelf at Edward Jones to change much either because of the KYP reforms. The firm typically takes a conservative approach to products — no alternative investments or structured notes — and due diligence is thorough.

When asked about potentially attracting clients with products, he said, “Our product is our advice.”

At Worldsource, Rizi said a few funds were cut in favour of better-performing managers offering access to the same asset class more cheaply. But the firm has also added product types: ETFs were added to its mutual fund dealer’s shelf in 2019, and liquid alts were added this year.

Rizi said his firm encourages advisors to inquire about existing products or prospective ones. “Advisors are our first source of contact for learning what their clients are interested in,” he said. Further, product discussions are opportunities to discuss the KYP reforms and due diligence.

Could the reforms keep dealers from offering popular or novel investments that clients may ask for, such as cryptocurrencies?

Firms would face due diligence work to add products that advisors haven’t historically offered, Roskies said.

Regardless, firms and advisors have a differentiator, he suggested: the white glove treatment.

“The CFRs are a bit of an advantage for the human element,” Roskies said. Advisors build bespoke investment plans, and the reforms address that human service by introducing guardrails. For clients who want advisory services but have concerns such as conflicts, “the cons are lessened, and the pros are increased,” he said.

When it comes to products, “You should be looking at all the benefits and features to make sure the investment you recommend is in the best interests of clients,” Rizi said.

“That’s what KYP is all about.”

What to consider when assessing an investment

  • Structure and features such as complexity, transparency, uniqueness, basis of return, likelihood of achieving investment objectives, expected returns, time horizon, liquidity and use of leverage
  • Compensation or other conflicts
  • Risk
  • Initial and ongoing costs and their impact on performance

Source: Amendments to National Instrument 31-103 (companion policy)

Tech to the rescue

Dealers have turned to tech to help maintain their product shelves — “not just from a compliance standpoint but from a data integrity standpoint,” Worldsource’s Richard Rizi said. A product shelf can have tens of thousands of active fund codes, which require updates when fund names, management fees and other elements change.

A dealer’s biggest concern with enhanced KYP is probably monitoring the product shelf for significant changes, he said.

Tech platforms provide alerts, product analysis, consolidation of advisor notes and disclosures, and suitability support, and can flag client portfolios affected by significant product changes.

Parham Nasseri, vice-president of regulatory strategy at InvestorCOM, which provides tech solutions, said flexibility is part of the firm’s KYP approach.

“This isn’t do-it-once and then forget about it,” Nasseri said. For example, firms may want to change or add to the mix of metrics they monitor, as he’s observed some firms doing in the last year of working with them to adapt to the CFRs.

For advisors, tech allows for “a consistent approach” to comparing products, Nasseri said. For example, on a mixed shelf, proprietary and third-party funds would be compared based on the same objective metrics, such as risk, cost and return.

Morningstar offers its fund scorecard framework for firms to analyze and monitor products. Higher-scoring funds exhibit higher Sharpe ratios, according to the firm’s research.

Using U.S. fund data, the variable that most predicts that outcome, and is thus significant, is a fund’s expense ratio — “an unsurprising conclusion,” the firm said in an explanatory document. “It is also worth noting that funds’ past performance is not as predictive as other factors, despite being used frequently by investors to compare funds.”

Qualitative factors are added to quantitative results to create the scorecards.