Compromised by its many biases the Brondesbury report completely misses the point about fees!

From one critical perspective this report appears to blame consumers of advice for the outcomes of a business model compromised by transaction remuneration.  Little is said of the inadequacies of suitability standards and their regulation or of the failings of investment processes focussed on the transaction.  Lacking such balance the report appears to advocate for the transaction model and thus is pared of its credibility!

If you had stopped reading the Brondesbury report into Mutual Fund Fees at the first summary conclusion on page 6, you might have walked away thinking the report was in favour of fees for the right reasons:

“Evidence on the impact of compensation is conclusive enough to justify the development of new compensation policies.”

If you had read on you should be left in some doubt as to how much of a marginal benefit a move to fees would have on investor outcomes.  The report appears to build an argument that suggests investor behavioural biases are the most important vitiating impact on outcomes and that advisors are merely responding to their transaction requests.    

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The Brondesbury Report & Cultural Bias in the Regulation of Canadian Retail Financial Services…

I am going to delve into the Brondesbury report shortly, but first we need to step back and look at the frame we are in, because neither the Brondesbury report nor the CSA have fully explained this.

The CSA have unfortunately addressed mutual fund fee issues separately from the wider problems in the Canadian financial services industry and, most notably, separate from that of best interest standards.  There may well be a reason for this!

Aside from the investment counselling/discretionary client portfolio management segment of the industry, whose standards and responsibilities appear, to all intents and purposes, to be ignored as valid reference points in current deliberation, the frame we are looking at is the one that holds the advisory segment. 

The advisory segment is still regulated on a transaction by transaction basis with responsibility for the transaction effectively lodged with the individual investor.  This is a simple parameter to parameter model that aligns risk preferences and investment objectives, adjusted for some nebulous assessment of investment experience (often arbitrarily assigned), to a product recommendation.  The product recommendation passes through the parameters.   In the Securities Act, for instance, the provision of a transaction recommendation within an advisory registration capacity is not technically considered to be advice.

The KYC is not a portfolio/optimisation process.  In fact, if you were to hand a KYC to an investment professional they would have to bypass it to a more sophisticated investment process to construct, plan and manage an asset allocation and security selection that matched a given investor’s risk preferences/asset liability profile. 

The current culture assumes that investors come with requests on a transaction by transaction basis, that the KYC process is effective and sufficient and because of its simplicity is therefore simply understood.  An investor in this frame should be able to own the transaction with the advisor only responsible for the product advice and not the management, or the construction or the planning.  If we refer to the careful delineation in the Securities Act, the investor is not actually being advised. 

In this frame “the culture” assumes that it is the investor’s own behavioural biases that drive mis-selling and that the advisor must accommodate these biases or risk losing business: I phrase this with reference to comments that I will, in a later post, draw from the Brondesbury report.

I have a number of issues with this framing of the KYC process and so, it would seem, did the OSC way back in the late 1990s and the early 2000s –note the FAIR DEALING MODEL and earlier Financial Planning Project initiatives: 

In 1999, the Canadian Securities Administrators committee on financial planning proficiency standards identified conflicts of interest in financial planning advice as a more significant concern than representatives’ proficiency. The CSA committee undertook to pursue this area as the second phase of the Financial Planning Project. Around the same time, OSC Chair David Brown determined that changes in the social and economic environment, and in the business structures and objectives of the securities industry, warranted a fundamental re-examination of the regulations governing the delivery of financial advice to retail investors. He recognized that our regulations are still product-based, as they have been for decades, even though the industry has moved to an advice based business model. In early 2000, the OSC launched the committee that has led to this Concept Paper.

The promise of service has long since exceeded that of the simple transaction. It has long since extended to the provision of advice that relates to overall financial needs and financial assets.  The process needed to manage these needs and assets is more sophisticated/complex than that provided by the KYC parameter model.

Today the KYC remains as the barometer of the suitability of product advice and the assessment of the suitability of advice.  In order to deliver the promises that the industry is effectively making the investor today you would need to move your focus of attention to a more complex and integrated service process.  In truth investors should be paying for the process and not the transaction.  Unfortunately the industry remains mired in a culture that rewards the transaction and not the process, and hence focus has remained on the transaction and transaction remuneration. 

If we are to deliver on the service promises being made we need to develop our processes and thereby raise our standards of advice.  By removing remuneration from the transaction and aligning it to the process, i.e. a fee for service process and advice, we change the industry from one focussed on transactions delivered by a rudimentary process to one focussed on advice delivered by modern technology and knowledge that better matches the promise.   At the moment advisors can effectively promise best interests yet remain regulated on the transaction.  This risks a disconnect between the processes needed to deliver the wider promise and those needed to satisfy minimum standards.

The Brondesbury report, along with many others, is stuck in the transaction mindset: 

It believes in a world where investors initiate and are able take control of their investment decisions, where the KYC is simple and effective in delivering investment solutions, where advisors are not promising a higher standard of advice and are hostage to investor behavioural biases and where advisors are not responsible for educating the investor over their process and disciplines.  It believes in a world where the cost to the investor of delivering the transaction solution is of equivalent value to the investor and where there is no other promise than the transaction and no other alternative spectrum of advice.  The report ignores the fact that today’s promises exceed the boundaries of KYC suitability and require more advanced processes that naturally differ from those required to deliver stand alone product recommendations.

The Brondesbury report is looking at the problem through the rear view mirror, replete with longstanding cultural biases that have impeded the development not only of higher professional standards but more efficient and cost effective wealth management solutions.  This is a very complex area. I will address some of the wider issues as I explore the Brondesbury report in subsequent posts. 

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I discuss issues with the current parameter to parameter suitability model in my submission to the CSA on Best Interest Standards in Appendix A.  Also in this document are a number of excerpts from many of my blogs on best interests and the KYC process. 

Also worth reading is “Fiduciary Obligations of Broker-Dealers and Investment Advisers” by Arthur B Laby. 

Are Canadian regulators ring fencing consumer investing behavioural biases in favour of transaction returns?

“we suspect that much of what we see as impact of compensation is just investors failing to make rational decisions.” P53 of the Brondesbury Report on Mutual Fund Fees.

I am in the midst of reviewing the CSA commissioned Brondesbury Report on Mutual Fund Fees and am ploughing through the reference material which supposedly underpins its conclusions.  Amongst the many nuggets I have unearthed is the following taken from “Investors’ Optimism: A Hidden Source of High Markups in the Mutual Fund Industry” :

Previous works have identified investors’ optimism bias towards equities issued in their domestic market. In particular, academic research on mutual funds has focused on investor’s lack of financial literacy. …These empirical findings of investor’s deviation from rationality are in line with our model’s emphasis on investor’s limited financial knowledge of the mutual fund industry.

Investors’ optimism bias can be closely related to their lack of knowledge of the fund market, leading them to choose sub-optimal benchmarks such as bank savings instead of low-cost index funds or ETFs. Besides, investors’ optimism bias is probably influenced and reinforced by the marketing practices of mutual funds, which promote the sale of fund shares.

The reference to sub-optimal benchmarks is both noteworthy and ironic because both the new Point of Sale disclosure documentation for mutual funds and the performance reporting requirements laid down in the CRM2 lack mandated performance benchmarks. 

Interestingly the Canadian Securities Administrators had earlier proposed a GIC or cash based benchmark for Point of Sale mutual fund disclosure documentation, but baulked at the last minute for a number of reasons. 

So why were Canadian regulators looking to implement “sub optimal benchmarks”?  Were they ring fencing consumer behavioural biases in the interests of transaction remuneration or were they themselves acting in ignorance?  We may never know but the point is an interesting one and much more so given the deeper contextual focus in the  Brondesbury report on investor behavioural biases (chapter 5):

“Behavioral biases of investors are not easy to overcome. Behavioral biases affect advisor behaviour (just as advisors affect investor behaviour), investor choices of investment, and ultimately, investor outcomes”

“Time is a precious commodity to most advisors. There is only so much time an advisor can afford to spend to overcome the behavioral biases of investors, regardless of how they are compensated”

Investor behaviour biases lead to sub-optimal returns and these biases can be confused with compensation impacts

Behavioral biases of investors are not easy to overcome and they are a key factor in sub-optimal returns on investment. This poses a real limitation of the conclusions we can draw from the research literature, when we look solely at clients of commission-based advisors.

If there is no comparison between different forms of compensation, one can easily be misled into believing that sub-optimal behaviour is the result of the advisor’s recommendations and not, at least in part, the behavior and attitudes of the investor.

There are two issues related to behavioral biases that must be mentioned here. The first is the question of who is responsible for overcoming the behavioral biases of individual investors. While helping clients to do so may be something that a top-notch advisor will choose to do, we are not aware of any rule or principle that points to de-biasing as an advisor or a firm responsibility, regardless of compensation scheme unless a failure to do so impacts ‘investment suitability’ in some way.

“we suspect that much of what we see as impact of compensation is just investors failing to make rational decisions.” P53 of the Brondesbury Report on Mutual Fund Fees.

This quick post introduces some of my concerns with the Brondesbury report and my belief that many of its conclusions and analysis remain mired in a transaction mindset that continues to beset regulation of advice in Canada.   Regulators and, it would seem, some esteemed others appear mired in a perplexing behavioural bias towards “what does and does not represent investment advice”.