Much has been made of the trend toward replacing mutual funds with segregated funds, and the shift away from the MFDA platform, in advance of the registration reform.

According to Paul Brown, president and CEO of Worldsource Insurance Network, in the last 15 to 20 years, a lot of insurance advisors became “hobby advisors” on the mutual fund side. And among these, a cohort loath to understand compliance is beating a fast retreat back to seg funds to avoid regulation by the MFDA.

“Now we’re starting to see mutual fund advisors who are very upset with their dealers because the dealers are trying to follow the prescribed MFDA rules,” Brown says. “The advisors are just throwing their hands up in the air. There has to be some kind of common regulation.”

Granted, a small portion of advisors may be playing a game of regulatory arbitrage, and skirting the rules of suitability. But the truth of the matter is there are far more sinister alternatives to mutual funds than the segregated fund.

There are also much less sinister reasons for the shift.

William Donegan, chief compliance officer at Scotia Securities, emphasizes seg funds differ enough from mutual funds not to warrant the same regulations.

“The risks are different. The structure’s different and they really shouldn’t be subject … to the same suitability and supervisory regime,” he says. “It would be a mistake to have one overarching, single regulatory regime for the analysis of products in the market. That would be a huge error.”

Neither the industry nor the advisor should be blamed for regulatory arbitrage, Donegan notes. It’s the government that’s at fault for constructing a system that drives advisors to do it.

The mutual fund is probably the best product for the typical retail investor setting up an RRSP, Donegan adds, and he anticipates continued strong demand. “But whether there will be a lot of people in the business willing to sell the product is another issue.”

One can hardly blame an advisor for taking the path of least resistance. All things being equal, a rational market participant will skirt the relatively heavy compliance regime of the MFDA channel, and conduct business either in the insurance channel, or as an exempt market dealer or investment counsel/portfolio manager.

They might also go the IIROC channel, accepting the tradeoff of having SRO oversight in exchange for an expanded product offering. “For dually licensed advisors, it’s been a fairly simple transition to move their business out from mutual funds and into segregated funds, and certainly the regulatory burden is much less for them to make that move,” says Ken Rousselle, president and CEO of Professional Investment Services (Canada). “Most MGAs have very limited suitability oversight when it comes to the distribution and sale of segregated funds.

Of course, there are other reasons—beyond regulatory arbitrage—an advisor would place a client in a seg fund rather than an equivalent mutual fund. The most obvious being that the seg fund is a better fit for the client.

Rousselle points out the aging population is looking for more secure and guaranteed investments, and so tilt in favour of the seg fund. This preference for safety has been amplified by the downturn that ravaged the equity markets between September 2008 and March 2009. Apart from actual suitability, there are other reasons for the dual-licensed advisor to place the client in a seg fund. MGAs tend to have lower transaction costs than mutual fund dealerships, and investment are usually processed faster, because the MGA has less legal responsibility to ascertain suitability than a fund dealer.

“Under the Insurance Act, there’s no definition of an MGA,” Rousselle notes. “In fact you’d be pretty hard pressed to bring an MGA into a lawsuit, because the role of an MGA isn’t defined. If anything, they’re more of an administrative, processing organization than they are a legal entity, with regards to the sale and distribution of insurance products.”

The danger with this shift toward more laxly regulated business models is that the industry is giving up what it has earned in professionalism. The mutual fund industry started out as a “cottage industry,” he said, and has only recently started to improve its standards, although he admits these standards might have become extreme.

“Now, we’re shifting that over to the segregated fund side where it’s loosely regulated, and we’re just creating another problem that’s going to have to be cleaned up five years from now,” he says. “In my opinion, that’s scary.”

Meanwhile, there’s a proliferation of products sold by offering memorandum; about the most loosely regulated channel in Canada. These products are flourishing in Western Canada, and include mortgage investment corporations and limited partnerships.

“The due diligence required on that is incredible, because of the real lack of regulation around those products,” he adds. “I got actual e-mails from these companies to advisors that say ‘Don’t worry about your dealership, it doesn’t matter that they didn’t approve it. We have ways around that.’ Does that take you back to Portus and all that stuff?”

Likewise, perfectly acceptable products can be misused by an advisor driven solely by sales, rather than building a holistic financial plan. Rousselle points to guaranteed minimum withdrawal benefit products as a prime example of an investment being misused by some.

“The danger I see is the product salespeople who are putting the entire retirement fund of the client in these funds, versus the financial planner who is understanding the product a lot more— its true benefits and drawbacks—and only placing a certain amount of money where it actually fits, like RRIF minimum payments and what-have-you.”