There are two opposing camps with respect to the compensation debate: Those who believe a fully transparent, fee-only model is the only path to professional respectability; and Those who see the current variety of compensation models as sufficient for the Canadian marketplace.
In my last column, I gave my two cents on this subject. My practice is a mix of both models, with some clients selecting a transparent and fee-based solution and others preferring a more traditional, commission-and-trailer-fee structure.
For me, there’s no conflict. I run a business where I sell professional financial planning advice and investment management. Clients can choose how they wish to pay for my services. While my preference is for the fee-based model — and this is the relationship my office encourages — we also see a place for transactional commissions and low-load mutual funds.
Frankly, I’m getting very tired of hearing from those who argue for a fee-only model as if this is the only way forward. I’d argue the Canadian investing public disagrees with them. The vast majority of Canadians engage in almost no financial planning, and the number who will pay $2,500 or more for a written financial plan is very small indeed.
And ask your favourite mutual fund company about their sales of F-Class mutual funds. Uptake here has been on the slow side.
At a recent debate hosted by the Financial Planning Standards Council, participants were told that Britain and Australia have banned embedded commissions.
And some argued the Canadian regulators should consider following their lead.
But before they get to trailer fees, may I propose they deal with other issues first?
After about 20 years in this business, I’ve seen several other practices that should be put to the fire, as they cause considerably more damage to Canadians’ financial well-being than embedded commissions.
The following are some examples of bad behaviour we should really be talking about.
Before anyone sends me a free copy of The Smith Manoeuvre, let me say at the outset: I get the math. On paper, leveraging looks great. Yet in practice, it’s one of the greatest wealth destroyers I’ve ever encountered. It’s not the math — it’s the application that’s the problem.
This strategy may make sense for a sophisticated, high-income and high-net-worth client with no debt who’s looking to maximize return and tax-deductible expenses.
But this is rarely the case.
Show me a leveraged portfolio, and I’ll nearly always show you an investment account filled with DSC mutual funds, sold by a novice financial planner to a couple who are already fighting mortgage, car and line-of-credit payments. The clients may have decided they can save a few hundred dollars a month, and rather than being advised to accelerate debt repayment or build a cash reserve, they’re shown how their monthly savings can support a much larger portfolio and have the magic of compounding work for them right away.
To make matters worse, they often pledge the mutual fund certificates as collateral with the bank, creating a portfolio that’s nearly impossible to administer.
The only rationale, in my opinion, for encouraging leverage is to maximize the commission cheques. So if you’ve built your practice around leveraged investing, quit it. You’re giving bad advice, damaging the financial health of your clients and only doing so to enrich yourself.
In my experience, most proponents of leverage represent the bottom of the barrel in the financial business.
Selling all of your mutual funds on a DSC basis runs a close second to leveraging in my book. Please note that I’m referring specifically to the original version of DSC, which requires a client to be locked into a given mutual fund family for six years or longer. With the advent of low-load structures, which only require, at most, a three-year commitment, there’s now no justification for the continued sale of DSC funds.
The most common argument I hear from DSC proponents for their continued use of this outdated structure is that they do a large amount of work at the beginning of the client relationship and feel they deserve an upfront commission.
Is it fair, they argue, to complete a full financial plan for a client, only to see the client walk away after a year or so? If they’re going to do the work, then the DSC model is the only method of providing for fair compensation.
If that’s your concern, then have the guts to charge for the plan up-front, improve your service — or get better clients. At the very least, use the low-load option and handcuff the client for three years or less. Some marriages don’t last as long as most DSC structures.
New-issue closed-end funds
When the next greensheet crosses your desk, or while you’re attending the next roadshow lunch, ask yourself one question: If this thing didn’t pay 3% commission, would I buy it? If you can do elementary school math, I sincerely hope the answer is “No.”
It’s beyond my understanding how hundreds of millions of dollars each year can go into these things. By the time the client owns the product, underwriting, structuring, marketing costs and commissions have eaten up over 6% of the investment.
There are some very interesting and unique investment strategies that are offered in closed-end form. If you really want to buy the product, wait for it to start trading and pick it up on sale. Search the closed-end market; nearly everything trades at a discount. If you’re patient, you can get your orders filled.
The latest innovation that plagues nearly every new closed-end issue I’ve seen recently is the addition of a warrant. This allows the initial investor the option to buy additional shares at some point in the future at the original issue price. These are offered as a sweetener to help move the issue.
Again, basic math shows this is not a sweetener — it’s a toxin. The vast majority of warrants expire as worthless. That’s fortunate, though, because if they were exercised, their only effect is to dilute the fund and devalue the existing shares.
I’ve noticed that most of the closed-end business is clustered around a small number of advisors. In other words, those who do them do a lot of them. As a manager, when I’ve reviewed their clients’ accounts, I see a mess of products that don’t have any process or structure behind them. They become a collection, not a portfolio.
Most of these products are the children of marketing departments. They’re launched to exploit a popular theme or trend in the market.
Whether focused on commodities, agriculture, covered call writing, a hedge-fund whiz, or whatever, they’re built to sell. Chasing hot themes in this way is the very antithesis of successful long-term investing.
Don’t believe me? Go and look at the track records. Nearly every closed-end fund brought to market in the past three years is trading at a discount, is below its issue price or is lagging its benchmark.
The new-issue business for closed-end funds doesn’t make economic sense for the client.
The upfront costs are high, the liquidity is lousy and the products are usually bought and ignored. Worse, they fill the client’s portfolio with yesterday’s hot idea that was bought right at the top.
A call to arms
Leverage, DSCs and buying new-issue closed-end funds — let’s talk about stamping out these bad behaviours, rather than debating how advisors are paid. To me, lousy advice and poor practices are the greater and more damaging obstacles on the road to professionalism.
Judging by the lower response rate (81 people) to a second poll, Harper Fraze’s so-called “bad behaviour” is not widespread, and primarily (62%) involves DSCs.