Is cash an appropriate benchmark for an equity based investment and just what is it doing in the point of sale document?

Canadian regulators are still implementing Point of Sale disclosure documentation for mutual funds, and FAIR, a regulatory think tank funded by the OSC and IIROC, has recently sent its submission on phase 2 implementation of the project.

Much of what FAIR says is spot on, but I disagree with their comment that a cash based investment is an appropriate benchmark for a mutual fund investment.


Most importantly, the asset allocation of the portfolio between cash, bonds, equities (and within equities to sectors, styles, markets and yield) should already have been defined by the investor’s risk preferences, financial needs, the advisor’s investment discipline and the portfolio construction planning and management methodology.  All this should be disclosed and dealt with before you even get to fund selection!

By the time you get to the fund or vehicle selection decision, you should already have dealt with the key risk decisions, and should be looking to buy the most appropriate and effective vehicles or investments to build up the portfolio to its recommended allocation profile.  

This is a vehicle selection decision, not an asset allocation decision, and I fail to see why a mutual fund company should be caught up with having to take responsibility for asset allocation risk decisions.  This responsibility lies earlier in the food chain!

Having cash as a benchmark risks confusing the investment decision as one between lower risk and higher risk assets when this should already have been dealt with in the portfolio construction process.   This section of the process should be all about the asset allocation vehicle, which means its costs, its risks and returns relative to the market and relative to its style.  At the very least we need a style based comparable benchmark.

Using cash as a benchmark would risk poor investment decisions by focussing investors on poor returns relative to cash at certain points and overly good returns at others.   Unscrupulous advisors would also be able to use the cash based performance to avoid the issue of the cost of active management and to influence allocation to active management vehicles.  

I think mutual fund companies would be justified in saying no to a cash based benchmark because this could cause investor confusion over the decisions they should be making at that point.   And, also, as discussed, why should mutual fund companies be responsible for portfolio decisions which should really be determined by the “advisor’s” suitability process.

However, that said, in Canada, advisors can operate on a streamlined transaction driven model without a fiduciary type responsibility or a requirement to operate in a client’s best interests.   This invariably means that the risk and asset allocation decision risks being shoved onto this point of sale document: investors have to make asset allocation decisions at the same time as investment selection decisions.  Quite frankly there is just not enough space on a Point of Sale document to cover all the bases.

This is also why the FAIR discussion of the need for a wider framing of risk in the investment selection process is also incorrect:

From FAIR’s recent submission: “Standard deviation measures volatility, and is not necessarily a substitute for an overall risk assessment, nor is it a proxy for retail investors’ use of the term ‘risk’. According to a retail investor report prepared for the Investor Advisory Panel of the Ontario Securities Commission, “[t]he perception of risk appears more closely tied to the questions [retail investors] were asked for their KYC form, rather than to any underlying notion of investment volatility.”5 The strongest criterion for an investor deciding not to buy a particular investment “is simply the Chances of losing money.””

The risk assessment process should be conducted before investment selection.  That it is not, and that a proper and full assessment of the relative risks of cash, bonds, equities and the bent of the portfolio have not been presented to the client, is more an indictment of the poor investment process standards of the industry itself. 

The mutual fund industry should not be footing this bill or taking responsibility for this part of the process.  This is the responsibility of the regulators and the “advisors”.  This is not just pure unadulterated bone headed, inept, laziness on behalf of Canadian regulators, it is also the result of decades of sleazy compromise.    

The current regulatory based transaction framework cannot properly regulate the fundamental processes that underpin proper investment advice.  That we have confusion and competing objectives in what should be a simple investment document is a reflection of the inadequacy of current regulation.  

Trying to make the POS stand in for the whole process is going to tie everyone in knots!   But worse still, such a deeply flawed document and rationale could well transfer a yet more onerous responsibility onto the consumer.   This document does not sit well in current regulation!    

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