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.    

I will dig into the conclusion more succinctly in a later blog, but for the moment I will address a number of biases that I believe constrain the objectivity of the analysis and confuse and compromise its conclusions. 

The report itself displays a naive understanding of the differences between investment processes that support best interest standard outcomes and those that merely enable product distribution.  It is more a defense of the transaction and the distribution of the transaction than an attempt to get at the heart of the fees versus commission debate.  

As I have said before, and in my previous post, much can be attributed to a misplaced belief in the sanctity of a simple parameter to parameter suitability model, a model that conflicts with modern day service promises.  To say that Canada does not understand this would be an injustice given the broad body of work conducted within the Fair Dealing Model.  Nevertheless, it is disquieting to find such antiquated views of the limits of the investment advice process still being advocated in a modern financial services industry.   

Bias number 1: while the report states that institutions have a right to profitability and compensation, it is remarkably silent on the rights of consumers with respect to their consideration.

Assumptions underlying (P 10) – “…we must recognize that advisors must be compensated and financial institutions must be profitable. There are legal and regulatory requirements that make this so.”

This is a contract after all and the nature and representation of the contract was the central issue in the Fair Dealing Model.  In this context I do question the handing of such important research to an organisation with so many industry affiliations.

Bias number 2: the report’s analytical frame does not consider the different service processes that often underpin the different payment options, but merely considers the different payment options within the product distribution model and KYC based suitability standards.  This limits the objectivity and scope of the research:

P6- “the aim of this research is to determine how the nature of compensation materially affects investor outcomes, when all other things are equal.”

In this frame the processes and the outcomes are assumed to be no different, only the costs of the outcomes differ, and this is reflected in the limited thrust of the report’s conclusions. 

A very important outcome of best interest standard processes are portfolios/solutions, constructed outside of the limited set of suitability parameters, that more closely match client needs and risk preferences, as opposed to a set of transactions that are independently determined, i.e. transaction by transaction within a narrowly framed process, and influenced by transaction remuneration.  In terms of promoting good advice you should reward the process that focuses on structure, on planning and the management of risk and return as opposed to a structure that rewards the transaction.  This is the most fundamental reason for favouring fees for advice based service than commission or trailers for transaction based services.

Changing the method of compensation while retaining the current frame surely stifles arguments for fees relative to commissions.  In point of fact, many fee based structures  in the product distribution meme are in fact transaction volume discounts as opposed to fees for advice based service processes.   Taking responsibility for the portfolio construction planning and management process within advisory services would change the nature of responsibility from suitability to best interest standards even though the investor would still give the yea or nay to the recommended portfolio profile and recommendations.  

If you think about it, it is insane to force the reward for a process that should be focussed on optimisation and personalisation onto a process that remunerates transaction by transaction. 

Fees are more appropriate to a focus on deeper advice based service processes while commissions focus on the transaction and transaction volume.  The following shows some of the reports misconceptions regarding the differences between disciplined processes and transaction frames:

P 21 – In addition, an unintended consequence of fee-based compensation is a propensity to keep the portfolio stable rather than seek better opportunities (reverse churning)

P 57 – Findings certainly indicate that commission-based advisors sometimes give biased advice that enhances their own revenue. Concerns about reverse churning and focus on proprietary (or related) products among fee-based advisors, suggest advisors with other forms of compensation can give biased advice too.

There is a world of difference between the lower cost fee based indexed investment structures and the higher cost fee for volume transaction accounts of many brokers.  To suggest that the reverse churning and other similar outcomes are the only options open to those seeking to introduce fees based services is misleading at best. 

Today’s “advisory” businesses have largely been honed within a transaction culture and retaining the sales architecture to assess the benefits of fees is a disturbing one.  One of the key themes in the FDM review was that the industry was changing and promising a different service option from the mere transaction and that regulation no longer covered this higher level of advisory responsibility.    

Bias Number 3 – The belief that outcomes associated with conflicted remuneration and the transaction processes they encourage are rooted in investor behavioural biases and  educational failings, that advisors cannot be held responsible for educating investors, are too busy to do so, and are merely responding to transaction requests.   

P45 – “Investor behaviour biases lead to sub-optimal returns and these biases can be confused with compensation impacts.”

P 50 – “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”

I would agree that there is much research that confirms investor behavioural biases where investors are making independent transaction decisions. The trouble is that a great many investors believe that “advisors” are making the investment decisions for them and the many “benefits” of financial advisory relationships are sold implicitly within most contracts. 

In a transaction culture where responsibility for decisions can be ascribed to the investor it is much easier for advisors to take advantage of investor inexperience and lack of discipline and to encourage inappropriate transactions.  The lack of advisor portfolio construction planning and management disciplines and responsibilities within transaction cultures that reward via the transaction is a key reason, in my opinion, for poor investment outcomes.   Unfortunately disclosure of how current regulation views the advisory relationship is not made known to the investor: to most investors they are to all intents and purposes in a best interest standards relationship where it is the advisor’s expertise and knowledge determining the recommended securities and asset allocations.  

I see no reference in the research noted in the Brondesbury report to direct causal relationships between investor behavioural biases and investment advice provided by investment advisors.  That does not mean that the culture does not allow for the abuse of asymmetry and manipulation of the KYC and by virtue of this creating a relationship.   I would suggest that the lack of advisor responsibility within standards governing the regulation of the transaction are a major reason for poor and inefficient outcomes.   Transaction remuneration incentivises this dynamic.   I have advised and I have seen much investor ignorance, but I have seen little of the type of investor that does not follow well argued advice. 

In my opinion the report overly focuses on attributing blame for poor advice to investor biases that are a) due to lack of experience and knowledge and b) that are also likely inculcated and encouraged by a transaction remuneration culture.  Much of what we see attributed to the investor is I believe the product of a product/transaction distribution culture. Unfortunately this relationship is framed as one in which the consumer initiates the transaction request. 

Most inappropriate investment outcomes are in truth the result of a suitability standard that focuses on the transaction.  Minimum standard suitability processes are a) incapable of managing complexity, b) conflicted by transaction remuneration and c) are afforded immunity via an outdated view of the client/advisor relationship.   

The Brondesbury report ends up blaming investors for the outcomes, for their own ignorance, for the system’s lack of process and responsibility.       

P 51 As we posited earlier in this chapter, the complexity of investor choices is the root of the problem. Experimental research shows that investors are often uncomfortable with the investment process, and instead of understanding the concepts, they seek shortcuts, heuristics, and opportunities to delegate that relieve them of the burden of understanding the complexity….

P53 …disclosure and rational discussion may not be enough to overcome behavioral biases. This is especially the case since many investors have no interest in this type of discussion. With 40% of Canadians failing a general investment knowledge test and many demonstrating unrealistic expectations for investment returns (CSA Investor Index, 2012), it is clear that many investors don’t wish to spend a significant amount of time on financial matters. Without a real comparison of investment decisions for investors of comparable sophistication using advisors with different compensation, we suspect that much of what we see as impact of compensation is just investors failing to make rational decisions.

76 While we know that most investors with advisors take the advice of the advisor, the advisor is guided by client preference in the selection of investments they offer. An advisor must accept the client’s wishes when clients want to ‘take profit’ early by selling a winner early or hold on to a losing investment until it ‘comes back’. The cost of this bias is documented and substantial. It is also difficult to dissuade return chasing and short-term thinking, which often push clients to buy riskier investments than they should, especially when riskier investments often provide better compensation. Working against ‘home market bias’ also means pushing clients outside their comfort zone. As well, while professionals look at the entire portfolio, retail investors tend to make ‘one-at-a-time’ choices about investments

P 76 All of these biases have a cost, and potentially, a good advisor can reduce the negative impact of these biases. There is conflicting evidence about whether commission-based or fee-based advisors are more motivated to reduce behavioral biases.….. For both commission-based and fee-based advisors, there is the potential of losing the client if they push too hard against their biases. This is a particular problem when investment objectives are aggressive but risk appetite is low. Telling the client the full truth, “You can’t achieve your objectives without taking more risk”, is a strategy that advisors believe can lead to their dismissal.

The report is ignorant of the bigger picture issues as well as the critical process demands of wealth management.   The current regulation of the transaction ignores the fact that services are addressing a much wider and a much more involved and complex dynamic.  

The greater impact on investor outcomes from a move to fees from transaction remuneration and to best interest standards from suitability is in the structure and outcomes of process.  Comparing total product cost under a fee versus a transaction return is only one minor aspect of the debate and may given the nature of the outcomes of process be an inappropriate one at that.   

The report compounds its sales/distribution culture bias by reiterating the belief held by the transaction based industry that they are neither responsible for educating investors nor for providing structure and discipline to wealth management solutions.  Similar comments were made in the Registration Reform Project documents and it would appear that this report holds similar such views: 

P 44 – 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.

P53 – 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.

P57- “the answer to whether advisors are obligated to de-bias clients (other than when a failure to do so leads to suitability issues) can only be a matter of policy. On a practical level, however, we can say that an obligation to de-bias clients would be time-consuming and costly.”

The report assumes that advisors are not responsible for educating investors but for funnelling requests, biased or not, through the basic parameters of the KYC.  In a bona fide transaction initiation this would likely be correct.  Where an advisor and their firm promotes their expertise and ability in providing wealth management advice and solutions then there is, I believe, a responsibility to explain their investment process, how they manage risks, how the portfolio is structured to meet the investors needs and risk preferences and education about the risks they are likely to face in the future, amongst other issues.  Client induction, risk assessment and education are key components of advice based service processes.  The investor is not learning how to invest, but how the advisor’s solution and expertise will manage their needs and their assets.  There is a difference!  

Again we see a cognitive dissonance between the requirements of advice based service processes supposedly providing recommendations that best meet the client financial needs and risk preferences over time and the requirements of a simple transaction initiated by the investor.   This is at the heart of the fee versus commission process.   The industry would like to keep regulation simple and limited to current suitability processes for good reason.  

Bias number 4 – The report seems to hold the belief that there is some divine natural process by which advisor and investor longevity ultimately lead to more experienced investors.  It appears to argue that what may appear to be the benefits of fees versus commissions in investor outcomes are actually the product of investor experience and not necessarily advisor experience/process and expertise.  

Client capabilities affect decision-making and thus affect outcomes. Wealthier clients tend to be older, better educated and have worked in higher-paying jobs. In general, they have more experience with investments and more knowledge of investment products. Yet to get to this point, they needed to be younger and less experienced investors first. The underlying question is really whether younger less experienced clients would do as well as older investors if they had fee-based advisors. Our opinion is that it is unlikely they would do as well as older investors due to their own lack of knowledge and the comparative inexperience of their advisors.  

This may well be the case where we have fee based pricing within a sales/product distribution culture, but this is certainly not an argument that should be entertained as is.  Again this seems to be advocating the benefits of the transaction/a transaction based remuneration culture.   At every step the report seems to be bending over backwards to support the current status quo. 

Bias number 5 – The belief that mis-selling of products is due to attempts by advisors to improve returns for investors and to address mismatches between investment objectives and risk preferences:

P68 – In terms of placing clients into higher risk products than their risk profile suggests is warranted, we speculated in an earlier chapter that this may be an advisor strategy to help deal with a mismatch between risk profile and investment objectives. In a 2014 InvestorPulse Survey commissioned by BlackRock Investments, they found that investors have consistently unrealistic beliefs about the income their retirement savings will generate, typically underestimating what they will need by 50% or more.  The report comments that inconsistencies between risk profile and attainment of objectives are likely to be at odds over the long-term.”

To assess the ability of assets to meet financial needs over time can be an involved exercise.  It is certainly an exercise that needs to be conducted at the overall portfolio level taking into consideration long term financial needs and an analysis that needs to be properly communicated to the investor.   Just because an individual’s assets may not be capable of meeting future financial needs is certainly not a reason to raise the risk profile of the portfolio.  There are a number of options one of which must be to consider reducing the withdrawal objectives.  Additionally, a structured approach to asset liability modelling and management would draw attention to the risks of taking on higher risk investment strategies.  To suggest that advisors are only helping to address these inconsistencies when raising the risk profile of a KYC or when recommending securities which conflict with a risk profile is indefensible and spurious.  

The other reason that the report focuses on with respect to mis-selling is that advisors are reacting to a wish to maximise returns for investors.  

P30 – The question that is unanswered is why advisors recommend higher risk products. In Canada, higher commissions for riskier investments may account for some of the preference. More broadly, there may be a desire to maximize return for clients……We speculate that advisors recommend riskier investments in the hope of getting better returns for their clients. They are motivated by a belief that clients will ultimately base advisor retention decisions on the amount of money they make.  This is consistent with investor behaviour for exiting mutual funds, but we have no direct proof that it applies to dropping advisors. Our firm has heard comments to this effect in interviews with advisors, but this issue was not central to those advisor studies . Since we did not systematically collect the information, this does not constitute empirically supported findings. 

It the statement does not constitute empirically supported findings then why make it?  The report would seem to be advocating for the transaction based industry and product/security distribution culture.  

Bias number 6 – Investor responsibility.   Again the arguments seem to be firmly focussed on investor responsibility for outcomes, whether it be failure to educate, their own behavioural biases or misplaced return expectations.  Advisor responsibility does not seem to factor into this.  I provide a detailed discussion of this particular issue in Appendix A of my submission to the OSC on Best Interest Standards.  Responsibility is key in advice based services, but it is advisor responsibility for structured, disciplined and well communicated processes that deliver outcomes in investors’ interests that is missing in current regulation. 

P 70 As a close to this discussion, we note that none of the regulation or impact studies look at the responsibility of the individual investor for their own well-being. The philosophical underpinning of the regulation is that investors need help because this is too complex to figure out on their own. While we don’t dispute that assertion, we contend that a discussion of individual responsibility is merited. To use an analogy, seatbelts are mandated to help save lives in the event of an auto accident, but it is the driver’s responsibility to handle their vehicle in a manner that makes an accident less likely. Perhaps there is a parallel in financial services regulation. 

Investors do of course need to make decisions but they need a discipline, a structure and an explanation of both on which to make that decision.  Investor responsibility is otherwise the straw in the wind, and again here the report belies an incredible naivity with respect to the investment process and client/adviser relationships.  

Bias Number 7 – The report appears biased towards the stance that commissions have broad appeal at the investor level. This stance appears to stem from an argument that experienced investors with larger sums of capital choose experienced advisors who respond to their demands for fees.  I am not entirely sure of the logic because it is not explained and there is no corroborating research in any of the literature that I have read that would support such an argument: 

P42 – If clients are segmented by wealth into fee-only and commission-only to form the mixed compensation of most advisors, it speaks to segmenting clients based on knowledge and sophistication. This is a possibility certainly mentioned in academic research, which views such a practice as geared to taking advantage of the less sophisticated investor. Alternatively, if most clients have a mix of fees and commission within client, it suggests that the combination has a broad appeal that meets the needs of both advisors and investors. We have no research data that bears on this issue.

Bias number 8 – Costs are the only benchmark of a fees versus commission culture!

P20 – A facile conclusion that one can easily reach from these findings is that investors will end up with more money in their pockets if both sales commissions and trailing commissions are eliminated.

If we believe that the total costs of product distribution under fees versus commission are the only differential worth considering we miss the natural delineation between fees and commissions, that is the process and the outcome of the process. A best interests recommendation may recommend no product at all!

P 69 – In academic research, much of the disadvantage engendered by biased advice is that the return on a recommended investment is greatly diminished by commission costs. When commissions are removed from the equation then return to the investor should be higher. As we pointed out earlier, however, the return to the investor in a fee-based regime can only be reckoned after all fees have been charged against the investment return. The research on regulatory impact suggests that while product cost is lower and advisors recommend more low cost products, the cost of advice and other fees (e.g., administration, platform) is likely to rise.

It is not yet clear whether the total return to the investor will be improved by the shift in compensation regime. Nonetheless, there may be other benefits from unbiased product selection, but as yet such benefits are not documented.

p74 – Based on available evidence about fee increases, it is not yet clear whether moving from commission to fees will result in a net improvement in the overall return to the investor, although it is likely that lower cost products will outperform those bought under a commission-based regime, given the negative impact of expenses on investment returns..

At the start of the Brondesbury report we find the following statement with respect to its objectivity:

It is important to state what the research will not do.

  • It will not advocate a policy, but rather it will summarize and interpret the evidence in a balanced manner.
  • It will not weigh in on the topic of the value of advisors.
  • It will not report on papers that are ostensibly research, but are in fact nothing more than opinion

I believe that the report does advocate for the status quo, for the transaction remunerated product distribution model as opposed to the advice driven service based fee remunerated models which are the aim of jurisdictions favouring best interest interest standards. 

The report does indeed weigh in on the topic of advisors but in a manner which lays the blame for poor investment outcomes at the foot of the consumer.  The report is full of opinion on the relative merits of commission versus transaction in a tone which differs materially from the research referenced in the report. 

In the end it is my belief that retaining transaction commissions is preventing the development of efficient higher quality advice based service processes in the Canadian retail financial services market place.   The report at hand is marred not just by its many biases but ultimately by its ignorance of key wealth management process dynamics!

Andrew Teasdale, CFA

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