Mutual fund fees (Canada)–perspective makes it all the more complex and pressing an issue..

“Over the last few years, there has been a wave of regulatory reforms and proposals in other major international jurisdictions that fundamentally change the way retail investors buy investment funds and other financial products, as well as how they pay for financial advice.”

I would have stressed that the changes made affect the way that individuals are advised and sold products by the industry, as opposed to the way investors buy products and pay for that transaction advice.

I have wanted to say something about the CSA’s consultation on mutual fund fees for some time.    I still think it is too overly focussed on making consumers responsible for the transaction decision than looking at ways of making the industry more focussed on the needs of the consumer!

Clearly mutual fund fees are too high if their objective is to help optimise investors’ current saving and future consumption decisions, and especially so for today’s low growth environment.     

It is also clear to me that the current distribution culture and its regulation is hindering pricing competition, and not just transaction pricing, but service pricing and definition.   

The consultation document refers to changes planned in the UK and Australia, yet regulation in these markets is years ahead in terms of their roadmaps: you cannot compare regulation in Canada to that in the UK and Australia where even key words like  suitability do not transpose. 

Many “advisors” clearly use initial transaction commissions and trailer fees to cover the cost of providing “other services”, even though these other services may just be to help facilitate transactions.  The trouble is, for the most part, especially for those operating on an advisory basis, (where strictly speaking they are not meant to be providing hands on risk and return management) it is often difficult to see just what the clients are paying for, and whether or not what they are paying for is of value.  But, if all you are receiving is the mutual fund management and the transaction, then fees and management charges in most instances are extreme.

If commissions are to be used to offset the cost of “important” services, just what will those services be?  The minimum standard, KYC framed, suitability process, in itself, is insufficient to properly construct, plan and manage an individual’s assets to meet their financial liabilities over time.  It is only really sufficient to effect product sales on a set of simple parameters, even though the implied service, the one the investor may think they are often paying for, may not be one which regulators wish to enforce. 

If the higher suitability standard services that many investors would want are not allowable under current regulation, how are you going to transition from commissions and trailers to fees for service? 

Clearly if you are in the business of facilitating “suitable” transactions, services must naturally wish to gravitate towards added added value frameworks that manage assets, relating them to the investor’s financial position and needs over time.   Investors also need more than just simple KYC, paint by numbers, “suitable” transactions.  Indeed, the transaction is the least important part of the process.

Therefore it is difficult to see how a number of “specific services” could be properly and easily framed, without some effort, so as to justify all the commissions and trailer fees received.  Getting “advisors” to define services that will soak up the trailers is not going to add value.

Getting rid of commissions and/or making sure that there is a bona fide service contract against which fees/commissions will be charged, is going to be difficult without a move to a higher suitability standard which would help define “added value” and the boundaries of responsibilities.  Otherwise you risk creating a contract exchanging money for nothing. 

Services worth paying for are those which would incorporate, to varying degrees, investment planning (including modelling), risk management and financial planning.  This is not to say that simple suitability transactions currently framed by regulation could not be set up on a fee for service basis, just that there is considerable doubt as to whether you could do so and continue to earn the same margins.

At some point in time, therefore, we will have to cross over into fiduciary type territory, and by this I mean that territory which covers the point up to which “advisors” are using their expertise and processes, and over which consumers are ignorant and rely on, to provide investment planning and to build and manage portfolios.    This is the only way we are going to get “advisors” to justify to some extent the commissions and fees they charge.  It should be extremely difficult to justify current cost/commission structures for simple transaction services.      

And of course, expertise and processes required for an advice based service process is a moot point – most “advisors” do not possess these, and to be truthful they do not need to as long as they can interface with systems that provide the expertise and the output.  But such developments (effectively advanced wealth management service distribution systems) will change not just the facade but the foundations of distribution and advice.

Moving the industry to this higher ground, and those who advise in it, will not be easy.   Such change will require different service processes, organisational structures, technology, skill sets and the interaction of these factors.   It will also need to acknowledge the reality that differing abilities of clients to pay will also influence the client/”advisor” service interface.           

Therefore, for many “advisors” it should be clear that there is no room, as is, under their current modus operandi, to move to higher service standards and still be able to earn current margins.   It may be that they lack the systems, processes and expertise to deliver investment planning/proper financial planning/portfolio services, or that they lack clients with the assets and income level to afford the cost of these exercises. 

This does not mean the industry should not be forced to forsake commissions and trailer fees.   It should be clear that we need more advanced systems that interface between the “advisor” and the public and that will provide the new framework for distributing products, securities, transactions and services – these systems will provide the integrated asset and liability modelling and management functions that will do the fund selection, risk assessment, asset allocation, personalisation, investment planning and portfolio management of risk and return. 

Ultimately most investors of the future will interface with these systems themselves, after being initially led through this interface by an “advisor/client relationship manager”.   This is where investment and financial planning education comes into its own, at the interface.  

Getting rid of commissions will ultimately get rid of most “advisors” and spur development of advanced service distribution frameworks.   Costs will come down: just consider the differences between compliance costs for the current framework where thousands upon thousands of “advisors” are selling whatever they can to that of systems and service processes where all outputs and sensitivities are centrally managed.   No more churning, no more inappropriate leverage, no more poorly diversified portfolios and an induction and education process that CYAs at all points in time.    This is where getting rid of commissions and forcing “advisors” to agree in advance both service and service costs will ultimately take us.

For some “advisors”, the switch away from commissions to fees will hardly cause a ripple.   But for the industry as a whole it will be a travail, and it will take time, and it is my opinion that Canada is still too far away from the point where it can make such change immediately. 

Australia and the UK have been raising standards for decades and they have been preparing for this moment, and even now it will take time for new imperatives to feed through to processes and structure.  

Canadian regulators will need to level up because messing with the remuneration without preparation and analysis as to its impact is strategically naive.   Also, merely allowing firms to define the cost of services, and allowing them to offset commission/trailer income against these is not going to solve the value equation, as I said above.  .It is not a question of painting a different face!

Clearly trailer fees and commissions need to go.   Trailer fees are not really a transaction remuneration, and where the advisor is only responsible for the transaction decision, (advisory services in Canada) what on earth is the trailer fee paying for?   Getting rid of commissions and introducing fee for clearly defined services would remove the types of conflict of interest that result in inappropriate leverage, complex illiquid products and churning and other misdemeanours.  If you are running a fee for service approach you will want to keep things simple, limit your work to what you know and understand and minimise the risks to the income stream you earn from that work.

If you want to introduce a best interests standards, let alone fiduciary type responsibility, you are going to have remove transaction based returns and force a focus on service, process and fees.

Getting “advisors” to agree in advance with the investor the cost and the content of the service will improve accountability as well as better define advisor and client responsibilities. It will also help consumer choice, engender service differentiation and the development of competitive service processes.   But these arguments should be obvious.

Keeping transaction remuneration while trying to cap transaction costs is bound to failure and risks doing little to change the culture and structure of the distribution model that lies at the root of high retail costs.  The market place is the best place to set prices, providing there really is effective competition. 

I also fail to see how Canada is going to change the outcome unless it acknowledges that a) advice led service models cannot be led by the transaction and b) that advice led service models are essentially fiduciary type in nature.   Realising that investment advice is complex, that in advisory relationships most investors are dependent on the integrity of “advisor’s” processes, expertise and resources to construct, plan and manage is a precursor to realising that an industry focussed overly narrowly on the transaction and remunerated by the transaction is not going to result, in general, in an outcome that favours the investor. 

If you believe that the transaction led parameter to parameter model that we have is sound, then we risk fiddling around at the edges of the problem.  The CSA need to come down firmly on what they believe is the optimal model: the transaction led model or the service based model.  

Perhaps a good guide as to the way they are currently leaning is the following excerpt from the report:

“Over the last few years, there has been a wave of regulatory reforms and proposals in other major international jurisdictions that fundamentally change the way retail investors buy investment funds and other financial products, as well as how they pay for financial advice.”

I would have stressed that the changes made affect the way that individuals are advised and sold products by the industry, as opposed to the way investors buy products and pay for that transaction advice.   One puts the onus on the industry to lead the way, the other the investor.  

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