My daughter was born with hip dysplasia. My wife, a physiotherapist, has helped bridge the information gap between us and the medical world. Information is power and having a skilled interpreter is invaluable.
The same is true for investment management. The internet and securities regulators make investment information readily accessible, but investor knowledge continues to lag.
Investment and financial advisors are meant to bridge this gap. Unfortunately, most advisors’ compensation structures don’t reward this important function.
The CSA mutual fund fee discussion paper provides comprehensive research into investor perceptions and industry practice. The paper establishes that mutual funds are primarily sold through advisors, whom seven of 10 investors incorrectly believe have a legal duty to place client interests first.
Because of sales incentives, suitable funds may not be selected. Market transparency suffers, consumers remain uninformed and price discovery between mutual funds ceases. This helps explain why fund fees are so high in Canada: advisors make buy decisions, and price competition among mutual funds is impeded.
An unintended consequence is that mutual fund manufacturers are best served by designing products primarily for advisors based on compensation, and not for investors based on risk and return. The discussion paper confirms that:
- trailing commissions as a percentage of total advisor compensation rose from 27% to 64% between 1996 and 2011;
- elf-regulatory organizations (SROs) do not require advisors to tell mutual fund investors about trailing commissions, CRM II notwithstanding.
Growing advisor dependence on undisclosed trailing commissions, which can be increased without unitholder consent, can lead to concealed fees that are subject to manipulation.
Regulatory efforts to improve disclosure, like the CSA Point of Sale Project, Fund Facts and CRM, overlook the fact that investors rely on advisors to read all relevant material on their behalf. Virtually all investment fund and fund wrap assets under administration, excluding ETFs, are distributed by channels overseen by SROs and involve trailing commissions. More disclosure is always good, but what if the intended audience—the investor—doesn’t read it?
As registered portfolio managers, my team and I treat clients’ money as if it were our own. We have a fiduciary responsibility to them. I mention this for two reasons: firstly, as disclosure for the comments that will follow, and secondly, because responsibility to clients is at the heart of the debate over mutual fund fees in Canada.
There are three main remedies to the problem.
1. Unbundle fees
The fund industry argues embedded commissions give small investors access to financial services that would be unaffordable if priced separately. Fee-only planners should charge hourly rates for actual work done. Larger fees at set-up reflect information gathering and risk profiling needed early in the process.
If investors can’t get the advice they need, the industry will provide default choices with diversification and risk controls suitable for long-term investing. The defined contribution pension industry has done so with more than 80% of new plan participants in default options that include target-date and balanced funds.
2. Eliminate trailing commissions
The Canadian fund industry argues that fee comparisons with other jurisdictions are unfair because marketing costs are excluded. It misses the point.
Assume a $10,000 portfolio growing at 7% annually with a 2% fee (no taxes or transaction costs). Every year, 2% of the investor’s portfolio moves to the advisor’s “bucket,” compounding at 7%. After ten years, the investor’s bucket has grown to $16,073 and the advisor’s bucket to $3,598; about 17% of the total return for the period. After 50 years, the investor has $107,274 and the advisor $187,297.
Sixty-one percent of the total return goes to the advisor. Apply a 2.5% annual fee—slightly lower than the median Canadian equity balanced fund—and 69% of the total return goes to the advisor.
3. Descriptive advisor labelling
Commissioned mutual fund salesperson; commissioned securities salesperson; salaried mutual fund salesperson. Regulators insist on clear product labels, so why not for advisors? Advisors using ETFs to bring client expenses down are on the right path. The financial services industry must lower gross costs before investors and regulators do the math.