Comments on IIROC’s proposed guidance on Order Execution Only Services

Regulation in Canada often suggests that investors should take responsibility for their investment decisions and to educate themselves (perhaps much more so than other markets and jurisdictions), and have placed their primary focus over the years on disclosure to force such (CRM, POS etc). 

The retail model in Canada is also often portrayed as one where the “advisors” are merely helping the investor to make his decisions, more of a tool almost that helps links the investor with the necessary products:

If you’re an experienced investor, you may want an adviser who offers a wide range of products and lets you choose. If you’re newer to investing, you may be more comfortable with fewer choices and more guidance from your adviser.

The role of your adviser is to give you helpful, informed advice as you build and carry out your investment plan.

The more experienced investor appears to be assigned an even more precarious position of heightened responsibility for their decisions, even within the supposed safety of the “the regulated recommendation”! 

Yet, a one dimensional IIROC consultation on Order Execution Only Services appears to take the opposite tack and paints a picture of a world where responsibility and education are risks even to those investors who have expressed a clear preference to invest on their own account.  

The CSA in its “Working With A Financial Adviser” (erroneously termed since advisors are not advisers) alludes to the fact that there are those who may “have the time, interest or knowledge to build a portfolio that fits your investment goals and comfort level with risk” but IIROC is apparently oblivious of the fact that you also need the tools to do so.  So what on earth is happening in Canada? 

Global Context – Model Portfolios and Robo Advisors

Regulators the world over struggling to reconcile “the regulation of financial advice and the recommendation” with the ongoing march of new automated services, models and tools that are springing up on online. 

The online medium is remote from the traditional face to face advice/sales model, a model where the tools and the models used to be on the advisors side of the desk and the investor was invariably without. 

Nowadays the models, the tools, the education and much more is available to the investor on the other side, opening up the options for those who want to take control and obviate the additional costs and risks of face to face advice, especially in limited accountability retail markets (i.e. Canada).  This is especially so where the quality and the cost of advice have been found wanting, or the strategy and personalisation preferred unavailable. 

The quandary is that many of the new model portfolios provide limited input for the on going management of personal financial needs – how the portfolio actually relates on a day by day basis to financial needs – and in most cases is incapable of dealing with existing assets.   The solution to a certain extent is incomplete and for those who are looking for advice and not necessarily want to make their own decisions, a face to face element, a traditional advisory component with responsibility shifted to the “advisor”/er is still a necessary requirement – note that the issue of responsibility in the Canadian retail financial services market place is an issue here in that in most cases investors cannot rely on advisors to act in their best interests, so the quandary is especially moot.

But, this does not adequately address the bona fide DIY investor who has a higher level of interest in a) making their own decisions and b) understanding and finding out more about how to select, construct, plan and manage. 

We know that DIY investors tend to be proactive with respect to a number of financial issues and would be more likely to look to models and tools as a means of making their own decision, or would be better able to accommodate the model portfolio with respect to their existing asset position and set of financial needs.  More research is clearly needed here.

We also know that a key vitiating element in risk is cost, and the extremely low costs of portfolio solutions from many of these models should not be underestimated.  Cost benefits, relative to higher cost retail solutions, in most cases quite easily overcome many of the structural shortcomings.  We also know that the limitations of many portfolio constructs with respect to being able to meet and manage liabilities are the same for both the robo/model and the advised segment as they are derived from the same constructs.  Therefore the constructs and outputs that investors receive online, at a fundamental level, may not necessarily be any different from the ones they would have received had they sought a professional face to face relationship, and so cost differentials loom large.

We also know that we are only at the start of the automation and investment option innovation process.  The number of strategic options available to DIY investors will also improve and provide much higher levels of sophistication.  Critically here we need to be able to delineate the dividing line between an investor who is a) clearly adopting a strategy and taking responsibility for the strategy and b) using models and tools to develop their strategy, as opposed to being advised and relying on an advisers interpretation of output.  This trend, as technology improves, is only going to develop. 

Regulators therefore need to be able to clearly delineate a) regulation from advice and b) the advised from the I am advising myself, and by that I mean that all processes and services require a structural integrity and a transparency (the root and hence regulation of the root) that would allow those who want to be advised and those who wish to make their own decisions (the fork in the road and hence the point at which investors are advised or not) to be adequately catered for. 

Does it make sense for a divide to open up in the world whereby only regulated investment professionals can have access to the tools and models needed to make their own strategic investment options? 

Because this is where we risk going if we get regulation wrong and clamp down on what may well be a natural evolution of structured wealth management solutions. 

In Canada where the retail distribution model builds in a much higher cost structure and allows for more complex, illiquid portfolio products as well as higher advisory risks due to attitudes towards leverage and the boundaries of suitability and investor responsibility, the divide is a stark one.  This is especially the case given that the Canadian model implies a high level of investor autonomy even within the advised relationship – many of the metaphysical conflicts international regulators are dealing with, in terms of the dichotomy between the advised relationship and the DIY use of the constructs that produce the same, clearly do not exist in Canada. 

Moreover, if we shut the DIY investor out from tools and models then we also need to be aware of the liability we are taking on board.   I have never really been a fan of the DIY scene heretofore, viewing it as a necessary evil in a Canadian retail financial services market place where any “advice” seemed to be allowed.  But it does have merit where the costs are low and where structures exist to allow DIY investors to make sensible decisions.  Technological innovation has changed the dynamics and likewise my perception of the rationale of taking such a route.  It is becoming more viable for those wish to make their own informed decisions, with provisos and these need to ironed out obviously.

To continue to place the DIY investor in a position where they are exposed to the risks of making ill disciplined, ill structured decisions, all the while profiting from such is clearly wrong – I reference in particular here the mutual fund trailer fee issue. 

It seems regulators are all too  happy to allow individuals to trade without the safety of models and tools that would provide a better foundation for the construction, planning and management of their assets and to be advised without the safety of true best interest standards. 

It is interesting to note, in Canada, that if an experienced DIY investor were to use a model portfolio tool to help construct their own portfolio universe that under IIROC proposals they would only be able to access the diversified outputs of such a model from advisers (registered advisers and not advisors) subject to a fiduciary standard.  Yet, for all those investors who do not wish to make their own decisions, and who have clearly expressed a preference for advice, they are allowed to use advisors held to a lower standard where the responsibility for the investment decision is still with the investor. 

And so to a more detailed discussion of IIROC’s proposed guidance:

IIROC appear to wish to take out choice and options and information and tools from the interface in which many Canadians invest on their own behalf.  

The consultation provides no suggestions in which model portfolios, tools and other interfaces can be incorporated into the regulatory frame.   The consultation only provides suggestions to take them out. 

Perversely the most obvious item for change, that of retained trailer commissions (for what precisely?), remains off limits and unspoken of….

Remove commissions from online products and you remove the overt incentive to push.  Remove or obstruct the introduction of tools to allow DIY investors to make better decisions and you end up pushing investors to a venue (retail face to face) where advisors are generally conflicted by commissions and where the investor may end up with sub optimal fund and portfolio choices. 

In whose interests are the proposed rule changes, or rather the de facto capping off of the evolution of DIY investing in Canada?  You could argue that direct investors in mutual funds, given the trailer fees, have never in fact benefited from their preferred choice to go it alone.   Additionally, if best execution is about obtaining the most favourable competitive market price then trailer fees I would argue clearly breach best execution.  

IIROC appear to wish to keep those investors who transact on their own account far from the integrated disciplines of planning, construction, valuation and frame; the tools in point of fact which professionals the world over would not be without.   So what is the intent?

Transactions emanate safer from robust frames than without, and we know from research on Canadian Advisors, Retail Financial Advise: Does One Size Fits All, that many advisors provide a) limited customisation, b) project their own preferences onto portfolio structure so that the portfolio “may deviate substantially from what is best for the investor” and c) provide performance that after costs ends up worse or no better than that passive lifecycle funds. 

We also know from much research that while direct investors outperform retail “advisors” (due to lower transaction and management costs), they are also less diversified and may clearly benefit from structural reference points.  There is an angle here that has not been given consideration.

So what is IIROC saving these investors from? 

What other options are there that can improve investor outcomes?  These are not really answered or posed by the consultation.

IIROC appears to wish to tilt the independent investor choice back towards the retail “advisor”, to the world of conflicts of interest, of limited accountability and responsibility, of high cost products, of leverage, of structured complex products, of money for old rope.  Or at least this is what it seems.  

Today’s technology is driving change, providing a framework and a discipline for investors who wish to invest themselves, to invest much more proficiently and to learn and to educate themselves.  Technology is linking the shoulders of giants (the universe of investment knowledge on structure, risk and return) to the person on the street, who wishes to take responsibility; not necessarily for complexity, but for the simplicity that is the environ provided by the fundamentals of structure. 

The basic efficient advice structure delivered at low cost is indeed a much lower risk option than the higher cost conflicted structures, filled at times with illiquid complexity that impairs portfolio structure (structured products and leverage).  Many investors who do it themselves may have only previously referenced the investment culture of the incentivised distribution system and may themselves be compromised in terms of their knowledge of portfolio structure and may well benefit from disciplined reference points. 

Perhaps this is another reason why IIROC may be targeting these tools; it is not that they are providing recommendations, but that they are providing lower cost options, in increasingly large amounts, that obviate the lifeblood of the distribution model.  Otherwise why the lack of creative solutions to incorporating tools and models within the transaction frame of the OEO and for changing the nature of the OEO structure itself.

IIROC quite rightly point out concerns over the development of push within the online sphere and this clearly needs to be assuaged but not by throwing the baby out with the bathwater.  Clearly we do not want institutions pushing products, complex or otherwise, to individuals, capable or not and of using tools to push their own agenda.  But, structural tools used to help DIY investors structure and manage their assets more efficiently need not necessarily be recommendations.   Additionally, we need a wider array of venues for investors to access what I would call remotely managed asset management services and I discuss these options later.

Are model portfolios provided by regulated financial institutions the real concern here?

I believe that the decision whether or not to go with a model portfolio should be on the decision tree of the DIY investor.

I would also point out that many on line services already provide model portfolios that investors can access merely by answering say a very limited set of questions: these model portfolios may either provide detailed structural components (high yield US bonds, domestic/international gov’t bond, corp bond, dividend stock, US/Canadian/Overseas/Emerging equity market allocations) and/or actual specific fund recommendations without the investor actually having to register or speak to anyone (I was able to do this no problem).   Such, it would seem is already allowed for by CSA regulations.  I am not necessarily endorsing this practise, but what I am saying is that there is an enveloping confusion as to what IIROC is doing and why and this I believe alludes to deeper problems within the retail financial services’ market place.

Likewise, financial planning is not regulated in Canada, apart from Quebec, yet it seems to be perfectly acceptable for financial planners to provide suggested asset allocations.  Nothing stopping the investor then going online and populating that asset allocation.

IIROC are looking at the order execution space, which is really no longer an order execution only space, as one bordered only by the dimensions of push and pull.  

If the DIY space were to live up to its billing it should not be a product/security purchase only space, but primarily a security/portfolio build/analytical space if the DIY forum is to be able to properly take responsibility for its own decisions.  Analysis that allows investors to properly quantify a high yield on a product, or the illiquidity and costs of a structured note tends to detract from the headline return or attention grabbing hook.   Yes, if we keep the OEO space as one where investors can only assess based on what is being told them by a manufacturer then we remain at risk of push irrespective.

The question of what is a recommendation and when advice becomes regulated is an interesting one and worthy of attention, but it is not insurmountable once we realise the online space can be both for people who want assets to be managed for them as well as for those who want to take their own responsibility.  

The on line space is also at arms length from the usual face to face persuasion and having the full view of the product/security space and the necessary tools to properly evaluate them seems reasonable in the DIY context.  Will IIROC proposals impact the necessary transparency that is an imperative of portfolio construction?

Additionally, there are a plethora of portfolio products out there already that are freely available for purchase on an OEO platform: note the balanced fund with domestic and international bond and equity allocations.  The selection is a bit more rudimentary but the point of sale documentation still provides similar links to relevant KYC data and the suitability of the product. 

If an investor is looking for a low cost portfolio that more closely matches their risk/return profile, and they are aware of their risk return profile, what should prevent them from buying a model portfolio with specific recommendations?  Just a point because it is contextually very similar and bear in mind that all products are already regulated: a model portfolio in itself should be subject to the same regulation that all investment products are and we already know that its suitability and risk profiles are already well defined.  Indeed, model portfolios could be subject to their own POS!  So the basic model portfolio we see in Canada is in truth a simplified advice construct that is applicable to a wide range of investors.

If regulators want to make sure that DIY investors are not being pushed towards these solutions they could quite easily get them to accept each of the model’s underlying assumptions and then require them to make their own fund/security selection.  I presume the models are drawn from constrained mean variance optimisers with a set of allocation restrictions (or some other sampling methodology that makes the allocations less sensitive to inputs) and risk/return correlation variables.  An other issue here is that it would no doubt raise the understanding of these models over and above that of many a retail “advisor”.

I think it is also worthwhile considering how regulation in Canada already views the responsibilities of investors with respect to the investment decision, especially in the advisory space.  There is no fiduciary standard in terms of the “advisor” taking full responsibility for the portfolio constriction process, risk assessment, planning and management etc.  Instead while the advisor is responsible for recording the KYC inputs, the suitability standard itself is quite wide and it is the investor’s responsibility for accepting the risk/return profile of that asset.   So the advisory space is fairly heavily a push with quite a high level of investor responsibility.   A model portfolio, along the lines of those we already see in the market place, is not going to be in conflict with the KYC parameters inputted by the DIY investor. 

There are of course other issues.  Validation of the algorithms and model outputs relative to a range of KYC parameters should be fairly easily assessed by regulators and would be a much easier service to police, so issues of suitability are surely not the main concern here.   Getting investors to sign off to the fact that they are not being advised, that the portfolio selected is a simple one, that they are responsible for ensuring that their risk profile is correctly determined, etc, etc should not be hard.

IIROC talk about familiarity with research reports, documents which can be quite detailed, as a key reason as to why a research report is not considered a push is also relevant here.  Many investors are becoming increasingly aware of the benefits of lower cost index funds and more passive broadly diversified asset allocation structures, such that if they are not being offered by the retail advisory sector, why then should they not take matters into their own hands and buy direct?

If IIROC are concerned about push, they would not be tilting the field in favour of the retail market place where push is indeed the name of the game.  

Individual investor choices, aided by fundamental structures and guidance should not be book ended by sales quotas and bonus structures, but by best interests.  This is where we should be headed: a services’ architecture focused on best interest outcomes, on delivering professionalism, and structure and choice and technological solutions that can accommodate those who wish to hand hold and those who do not, those who have complex needs that require face to face and those who do not and/or wish to interact remotely from that expertise, but with the help of its disciplines, systems and structures.

Removing the architecture of push while developing that of pull would make some sense: removing trailer fees and other commissions from products while including more modelling and tools to allow investors to better manage their portfolios would do just that.  Again I reference the fact that the DIY culture in Canada seems to be a much more acceptable one and in keeping with its regulated stance that investors, advised or not, should be held responsible for investment decisions.

We no longer live in a technology neutral environment: can regulation afford to be tech ignorant?

All the components of the current Canadian architecture (IIROC/MFDA, ROBO/PM) all point to a technological future where transaction outputs from structure, where transaction is efficient but secondary to structure and where it would be insane to have a platform for wealth management construction for the private investor that removed structure and discipline.  Such would be but a dead end, a wasteland of irrelevance, a backward move to the days when the order execution model itself was little different from the broker model of the transaction by transaction. 

We have all moved on and so it should be time to move the OEO model onward into the future instead of plunging it into the abyss of horse and car antiquity.    

I reference “CSA Staff Notice 31-342 – Guidance for Portfolio Managers Regarding Online Advice” with respect to tech neutrality of regulation.  Is this regulation really tech neutral or is it terra biased?    Robo advisers are still required to have some interaction with investors, albeit limited, unlike other jurisdictions.   Given the nature of the portfolios and the assumed limitations of the models as such to accommodate tailoring, it would seem that the element of discretion with regards to the portfolio beyond the initial agreement and selection is actually fairly limited.  Advisers-ARs (I cannot be certain because I have not seen examples of deviations from the model where they may exist) are likely not providing much which could be qualified as advice beyond that seen in the model portfolio, especially with respect to the focus of current regulation which is advice leading to a transaction (buying/selling).   Regulation is therefore not really tech neutral, but tech averse given that the preeminent requirements of suitability, albeit quite limited if you review the questionnaire on Robo sites, are clearly covered.  Portfolio recommendations are also likewise more than likely in most instances to pass the suitability test for the range of profiles considered, especially when we consider the range of portfolio distributions considered acceptable across the retail domain.   There is likely a logjam at the regulatory level with respect to online wealth management services that is clearly not tech neutral, but tech averse and status quo influenced.

In case IIROC and the CSA are not aware, financial services, in many variants, are moving online and they are moving online for a variety of reasons; none of which are in truth due to excess regulation taking out “advisors”, although higher regulatory standards should indeed, if properly structured, influence the competitiveness of service delivery in this segment (a +ve):

  • The primary reason is that investment disciplines, structures, planning and management can all be automated via a relatively small set of decision rules (how structure adapts to liabilities, investor risk profiles, relative valuations/correlations/risk (and its many dimensions)) and assumptions, amongst which governs a) risk and return, b) how a portfolio adjusts to changes in inputs (relative prices/benchmarks, mean variance stats etc) and at the extremis of current tools, c) liability modelling, planning and management.  
    • Advisors who would otherwise deliver sub optimal frames, and whose only raison d’etre is to sell, are bypassed.  Bypassing this layer increases margins/lowers costs.  We are then faced with the simple problem of how do we best deliver this construct and the answer has to lie primarily with internet delivery and interaction in its many variants.
  • We are no longer constrained by a limited supply of experts for whom it may only make financial sense to deal with clients of a higher net worth. 
  • For clients of a lower net worth it makes sense to seek less tailored options with lower costs.  This imperative has always existed although the options have heretofore been limited. 
    • The limited supply of expertise, and the larger reach of a large body of knowledge,  is now being centralised and softwarised and moved to the wider market place.  The medium is of course online services and the sophistication of services are expected to develop over time.  Regulation can no longer afford to be tech neutral!
  • The development of higher quality investment advice structures enables disciplined structures that meet best interest/fiduciary type standards (with respect to the process itself and responsibility for the process and its communication) to be delivered to the wider market place.  The risk of unsuitable products and/or unsuitable structures and excess costs vastly diminishes in a well regulated environment that fosters innovation and competition. 
    • Moreover structures that allow for the modelling of the impact of products and securities, structures that IIROC are decrying as push factors, are in truth pull in that they allow more sophisticated DIY investors to properly screen the impact of products and test the marketed assumptions.
  • We know that standards of advice, process, training, professionalism and education and conflicts of interest, in the main, vitiate the delivery of structured advice in the face to face retail product distribution market place.  We know that this market place is characterised by limiting factors and is not optimal, at least in its whole.
    • The risks of unsuitable advice diminish with the softwarisation of best interest standard/fiduciary type investment disciplines and appropriate options available for induction for clients with different capabilities and service objectives.  The system actually checks for KYC integrity and in advanced systems is capable of predefining suitability for the universe of relationships – the nature of the asset management/risk profile/risk/return/liability universe means that it is perfect for systemisation.
  • Basic advice is being commoditised/made increasingly cost effective and improved, and it can only be done so via softwarisation which also expands the reach of advice.   So why prevent the spread of this trend, why we tech averse and why retain regulatory structures that favour an imperfect advice delivery structure? 
    • We know that standards of advice, process, training, professionalism and education and conflicts of interest, in the main, vitiate the delivery of structured advice in the face to face retail product distribution market place.
    • We know that the risks of unsuitable advice diminish with the softwarisation of best interest standard/fiduciary type investment disciplines and appropriate options available for induction for clients with different capabilities and service objectives. 
    • Areas requiring specific expertise remain the domain of professionals, but most investment planning revolves around flows, assets and asset characteristics that have an all roads lead to Rome fundamental homogeneity even within diverse universes.
  • The necessary distance between advisor/er and client, that reflects the sophistication of process, increases in an online softwarisation domain where centralisation and automation replace the supposed expertise of the average advisor.  All that remains in essence is the relationship and a generic guidance of the recommendations of either the system or how to use the system to adjust for client preferences.  It is this to which regulators are expressing an irrational fear; the supposed chaos of online platforms that compete with the long regulated face to face transaction model that is so well entrenched and protected in Canada. 

So technology provides a medium for investment discipline to be delivered to the investor taking away a large slice of the traditional suitability risks.  Transactions become secondary, or rather dependent outputs.  In this respect IIROC are correct in highlighting the necessity for accountability of the foundation but wrong in suggesting it has no place.  It is the other way around in that without the frame the transaction cannot have integrity and without integrity in a world capable of delivering such, the order execution only environment becomes a non sequitur. 

What becomes important is defining investor interaction in this environment; we find that the proficient direct do it yourself investor will have a predominantly pull relationship (pulling out of the universe of choice that which matches their world view etc).  Less proficient DIY investors may even start to move back to one of a passive relationship accepting of the fundamental boundaries of the advice structure.  

In this new environment investors have the following range of choices:

  • Hand holding: they can choose to have their portfolios and finances managed personally and benefit from the hand holding that goes with it: this costs extra and there is a trade off between the benefits of enhanced personalisation that this service may offer and the impact of costs on the outcome.  
  • Nevertheless, aside from the hand holding and perhaps more detailed planning and management than that offered by the still limited personalisation of ROBO portfolio constructs, portfolios in this domain will become managed via centralised constructs, if they are not already so.
  • The age of each professional constructing a portfolio from the ground up for each client profile should be a thing of the past.   Suitability in the very real sense of the word is a framework and this framework is the centralised processes that govern asset allocation, security risk/return management etc.  We delude ourselves if we believe that suitability is and always will be defined at the transaction level from a face to face technology neutral relationship.
  • They can choose to use an online service via an induction process (initial guidance by client relationship manager skilled in the use of the system and the universe of options available) that uses disciplined structures to automatically manage assets – note that this is not “auto no human involvement” since the central asset allocation/security and benchmarks management as well as input and manipulation of planning data should be managed as would the return assumptions. 
    1. Here they will rely on a client relationship manager to explain the process and do the initial planning and analysis via system tools and provide reporting/reviews over time.  The investor will need to respond regularly for updates to their financial situation and/or risk preferences to keep the systems updated.  This is not a hand holding face to face service and hence has a lower cost structure than option A.  It is a remote relationship, similar to that of the current regulated ROBO relationship.
  • The investor can also choose to access an online remote management option with no on-going hand holding and may well transition to this post induction.  They would be responsible for updating their financial profile to allow the system to properly structure plan and manage.  In this situation all the inputs, allocations, risk management, security selection would be handled by the remote asset management services.  The investor does not make asset allocation/security selection decisions but would interact with the system for financial/investment planning, budgeting/saving/spending decisions.
  • For those who would be considered proficient DIY investors: the investor who wants to manage their own would use the architecture around which portfolios are constructed planned and managed to house their assets but would be able to determine their own benchmarks, run their own security selection off their own valuation, allocation and management frames or a hybrid referencing system benchmarks.  DIY investors could select their own investment style and/or security selection.  This may also involve selecting one of a set of preset allocation and security selection benchmarks appropriate for their investment preferences, or completely determining their own security selection. 

All of the above would need efficient transaction implementation, which is what a discount broker is meant to do.  As far as the self select investor is concerned, the portal through which they would transact would be that of the discount broker or some such similar construct that may end up being no more than a back end to a more detailed system.  Indeed the systems of the future may not actually have discount brokers per se as know them at the moment.  

In truth what we see as the constructs offering advice and transactions today may not exist in the future, as is.  Regulation therefore needs to be mindful of allowing for competitive evolution. 

As we progress technologically, we realise that a discount broker on its own is likely to become irrelevant.  The base of the investment process, as far as wealth management is concerned, lies in the construction, planning and management and modelling tools, the research and the valuation, allocation and management platforms, whether this be mean variance optimised or some other valuation/relative valuation construct.  A direct investor without a platform is an investor that is unlikely to be able to manage their assets efficiently.  Or is that the intent of IIROC regulatory intervention?  Canada likely needs its own version of the FCA’s Project Innovate and their Robo Advice Unit.

Technology is likely to break down the current divisions between the service option regimes available to investors.  

So what are options do we have in Canada for investors?

  • We have the portfolio managers registered with say the OSC (in Ontario); these offer portfolios regulated under a fiduciary standard.   They are also face to face to relationships.  The transaction is outside the model (investor does not contract directly for transaction purposes) and assumed to be made efficiently.  High minimum assets are required to access most of these managers.
  • We have the Robo advisers, who are registered as portfolio managers and who require some form of limited adviser/investor interaction.   These are structured as remote low cost advice vehicles with no face to face relationship and the transaction is outside the model and again assumed to be transacted efficiently.
    • Personalisation is limited with no personalised investment planning (portfolio allocations being specific to the actual size and timing of client financial needs) per se being conducted, though portfolios are broadly reflective of risk and liability profiles;
    • The product is a portfolio constructed along a limited parameter base (similar to those noted in the KYC), but characterised by substantial diversification and low costs;  
    • For investors looking for higher personalisation/style tilts/direct equity/bond/pref/etc allocation, leverage and or ability to under/over allocate relative value, options are limited.
  • We have dealing representatives regulated through IIROC and MFDA: this segment, which tends to deal with the largest number of investors, remains regulated in accordance with transaction based relationship norms. 
    • This is a face to face model with transaction remuneration supporting the operations of distributors and advisors. 
    • Transactions and product costs, as far the investor is concerned are high. 
    • For investors who want well structured/personalised portfolios with low costs and more focused investment planning, options are limited and dependent on expertise of advisors selected. 
    • Accountability for risks of strategy and structure are overly weighted towards the investor.   The order execution and or Robo area may be the better value alternatives many for many small to medium sized investors.
  • The order execution only segment: investors are here for lower cost transactions, although mutual funds, and similar products, still pay trailer fees. 
    • Investors who use this segment either feel capable of managing their own money or are put off by costs and service limitations of other options. 
    • Service options of this component are constrained by its regulatory window.  IIROC review looks to be an attempt to prevent this model from evolving towards providing a more complete alternative to the higher cost advisor driven distribution model. 

As it is, If investors wish to manage their own assets they really only have one option: the order execution only.   Yet the ability to carefully construct, plan and manage risk and return is dependent on the supporting architecture.   Quite possibly the developing sophistication of the online model and online investors and competing online services, both domestically and internationally, are driving change in this area.   It is clear that the transaction is not the base of the investment process, rather its end, even though for those engaged in shorter term trading and more sophisticated strategies it has greater import.. 

Is their any merit in IIROC’s consultation and proposed guidance?

Complex products and leverage

On the one hand IIROC believes that it is acceptable that a range of complex products and leverage be available to investors on the Order Execution Only Platform: many of these investments are highly complex, highly leveraged with difficult to determine effective return distributions and costs to return.   I have no issue with this providing that the tools, where these exist, to properly assess the risks, costs and portfolio impact of such investments are made available to DIY investors.   However, margin is something which is usually offered at account opening (from my experience), and I would suggest that this is indeed a push.   Should margin actually be part of account opening at all?  I think not.  Investors need to come to the issue of margin themselves, just like model portfolios etc.

The definition of recommendation

IIROC expands its definition of recommendation in its consultation to include any communication (which includes any tool offered), or statement or opinion sent or made available to an investor:

“a “recommendation” means: any communication or statement of opinion sent or made available to an investor that could reasonably be expected to influence that investor to make an investment decision regarding a security”

“The phrase “any communication or statement of opinion” should be interpreted broadly to include, but not be limited to, any tool offered by an OEO firm, any direct or indirect communication sent or made available to an investor by an OEO firm (e.g., a posting on an OEO firm’s website, a message sent to a client(s), any form of communication or statement of opinion (e.g., written or spoken).“

Importantly IIROC does not “distinguish between the terms “recommendation” and “advice” for purposes of this Guidance.” 

Other jurisdictions do not consider advice per se as a recommendation: note the UK and FG15/1 Retail Investment Advice finalised guidance which discuss many instances where advice is not a recommendation, where it clearly delineates that not every communication or statement made available to an investor is a recommendation.  All valid information influences the investment decision.  

Clearly what should be at issue here is not the fact that an investor is supposedly on an order execution only platform to buy on their own account but that no specific recommendation for an investment is made to that investor and that no attempt is made to manipulate that investor via communications that attempt to hide the fact that a specific recommendation is being made.  The market place is always vying for a place in the investor’s portfolio, that is the nature of the market place.  The order execution site should not be a veil around which recommendations and conflicts of interest are pushed.   Do these sites have deals with product manufacturers, do they benefit from selling the products of their parent company, do they earn returns on transactions not related to the processing and administration of transactions?

It is plausible that what we are seeing is an attempt to prevent these sites from developing into services that help investors manage their own money.   Other jurisdictions have looked to encourage the development of on line services, notably the FCA, while still regulating the dividing line between advice and recommendation.  Note the following from the FCA Guidance Consultation “Clarifying the boundaries and exploring the barriers to market development

“The development of technology over the past few years has allowed firms to introduce more innovative solutions for helping customers by providing services through the internet, some of which involve giving personal recommendations and some which do not……We have seen a number of web-based tools, designed to aid decision-making and steer the customer to consider their investment options and solutions without necessarily providing a personal recommendation. ”

“For some time we (and our predecessor the Financial Services Authority) have set out our view that a well-functioning retail investment market needs different delivery mechanisms in order to be fully effective for a broad range of potential investors. We have recognised that there could be benefits from well-designed, low-cost methods of meeting customers’ straightforward needs, and we encourage their development”

The CESR document “Definition of Advice Under Mifid” also provide considerable leeway for the publishing of information and communication on the websites of service providers, something which the IIROC consultation effectively bars:

“…any direct or indirect communication sent or made available to an investor by an OEO firm (e.g., a posting on an OEO firm’s website, a message sent to a client(s), any form of communication or statement of opinion (e.g., written or spoken).“

In other words it would appear that IIROC is preventing the OEO service option from developing into a fully functional DIY portfolio management website.  Quite possibly this is because these sites are considered routes for a wider array of investors looking to manage their own money outside of the traditional face to face retail distribution market place.   In this case, reform the retail advice market place!

I can understand the need to prevent these sites from being used to push products onto investors and from being used to sell advisory services without the necessary accountability, especially if higher standards in the retail face to face domain slow product sales, but the breadth of the proposed guidance suggests that this is may not be the main concern. 

Additionally there is clearly a need to provide enhanced wealth management service options for those who wish to manage their own money online, as well as as a wider array of online service options for those who wish to have their assets managed for them, but more cost effectively and efficiently: the costs of the main retail avenue for advice as well as the additional suitability risks make the online market place, drawn off centralised disciplined investment processes,  a much more attractive option for many investors.  

It would appear that suitability outcomes from model portfolios are less random and risky than those emanating from the retail face to face channel, so it is rationale for investors to seek avenues that exploit the consumer benefits of this qualitative differential.   Many of IIROC’s concerns are likely due to regulatory failure.

The universe of investors is clearly more diverse than the current available service options, a great many of which are clearly compromised in terms of conflicts of interest and in terms of structural investment integrity.

Model Portfolios and Investment Tools

IIROC regards any tool that uses client information to provide asset allocation, benchmark, portfolio relevant analysis as a recommendation.  It does not consider portfolio analysis tools that focus solely on the current state of play of a portfolio as breaching these guidelines. 

IIROC views any tool offered by an OEO firm that uses client (or class of client) specific KYC-type information (e.g., time horizon, risk tolerance, etc.) as a recommendation.

A tool offered by an OEO firm may be a recommendation even where it does not use client (or class of client) specific KYC-type information (e.g., a tool advising a client to be in a particular class of security without having assessed any KYC-type information

As model portfolios could reasonably be expected to influence clients’ investment decisions regarding securities (including classes of securities), IIROC views any model portfolio made available by OEO firms to their clients as a recommendation and accordingly a violation of the No Recommendation Condition. As such, model portfolios should not be made available by OEO firms.

My concern here is that IIROC appear to be taking away the necessary analytical and structural support that most professionals have in situ when constructing, planning and managing portfolios.  Many retail financial advisors will use tools with in situ assumptions (provided by either the parent firm or third party software provider, or 3rd party research).  DIY investors also need tools that can react to their own financial needs, risk profile, time horizon etc and I see no valid reason for excluding these tools from the direct DIY investor’s tool box.   This is especially so when we note that regulatory communication implicitly discusses self directed investment as a viable option:

Getting advice may be worth it if you’re not comfortable putting together an investment plan or choosing investments on your own. For example, you may not have the time, interest or knowledge to build a portfolio that fits your investment goals and comfort level with risk.

A portfolio construction, planning and management tool would allow investors to enter their own benchmarks and assumptions and to incorporate their own securities and product risk/return characteristics.  They would take ownership of the model and its outputs, but the transaction decisions would be their own.  Providing such models would require a higher level of supporting guidance and educational input.

Clearly, if portfolio construction tools of varying sophistication were provided on site to investors there would be very real competition for the retail “advisor” model.  I doubt however that those investors who lack the confidence, knowledge and financial literacy to use such tools would do so.  In this context we are really looking at the need for a more diverse online set of wealth management services for both manage your own and lower cost remote management options.

Personally I believe that most investors should not be attempting to manage their own assets, although they may be able to interact with such systems over time. 

By this I mean determining the investment discipline/relative market or security positions/asset liability structures/risk and return assumptions and fund/security selection that plan, structure and manage and inhabit their portfolios.  Most would be better off with either a face to face relationship or a remote management relationship, but even here a great many would be able to use the software options to aid them in their financial planning.  

IIROC are clearly not knowledgeable enough about investment/financial planning imperatives to be making the types of decisions that could have long term detrimental effects on the development of advanced technological solutions for the management of personal financial wealth.

Part of the problem in the present market place is that retail distribution is involved in a fairly intense battle aimed at maintaining margins on high cost product distribution and the fairly low “suitability standards”.  This is pushing investors who may not be ready to move, into the DIY market place.  This is no reason to shut off DIY evolution though.

Part of the incentive for investors to manage their own assets is the cost differential of many an advisor portfolio and the qualitative differential vis a vis most model portfolios: many of today’s model portfolios being absent complex/illiquid products, closet high cost indexers, inappropriate leverage and the often unwelcome bias of the advisor’s own ill considered preferences. 

What we know is that we can deliver asset allocation and security selection from KYC data via basic models today at a fraction of the cost of the typical retail outcome.  There should therefore be little incentive for the average investor to even attempt to manage their own money in this particular space. So the divide that IIROC feel they may be facing, i.e. the un-serviced small to medium sized investor forced into managing their own assets is not something that is going to be allayed by cutting off models and tools that would otherwise help guide investors.   This is not an investor protection initiative.

I do however feel that a great many investors are capable of having a remote relationship with a centralised and automated asset allocation and liability management system that allows the investor to update their personal preferences and circumstances, to engage in what ifs and therefore to help in their own saving and short and long term retirement planning.  Most investors will be able to own their investment strategy if not always being able to construct it. 

Model Portfolios As Products

One thing regulators forget is that many model portfolios are de facto pre packaged portfolio products, much like a mutual fund.  Whereas on the POS the mutual fund is labelled low risk, medium risk and stated as being suitable for an investor with income, capital preservation or capital accumulation objectives, so is the model portfolio similarly delineated.  A direct investor is able to buy a mutual fund, and indeed, an advised investor is effectively required to sign off on such a fund purchase on receipt of the POS.  Providing the KYC parameters and the fund match that is really the end of it.  Similarly with a model portfolio the KYC parameters must match the model portfolio recommended.   Where is the difference in reality?  

What a model portfolio cannot do is tell the investor which of his securities to sell, but it can certainly help an investor identify, based on the model, where they be over/underweight.

The solution

The solution is not to close down the service options available to investors who wish to manage their own assets but to open up the service options and make regulated online wealth services more freely available.  This would mean freeing up the discount brokerage sites to service investors who also wish to use remote but regulated asset and wealth management services.  The costs of basic asset allocation advice and management are small as we know and the real differential cost is not something that would push an investor into a DIY stance unnecessarily.  

Why should discount brokerages be disconnected from the disciplined constricts that professionals use to construct plan and manage? 

The incorrect answer being pursued by IIROC may be found in the root of the service itself: clearly it sprung from the trails of the brokerage system where the services offered by the broker were primarily transaction based.  We know this transaction focus to be limited and not the prime determinant of advice and hence cost became a key differentiating factor for those investors who know what they wanted to buy and sell.  

The present IIROC consultation looks to restrict the order execution only model to its original focus, that of order execution.  However, the investment services universe has moved on considerably since its origins and just as the retail advisory segment is having to upgrade to account for the importance of advice and its fundamental underpinnings, so is the order execution market place, which for those looking for structured frameworks to manage their assets is becoming increasingly constrained.

In truth, the options available for investors looking to manage their own money should cover the whole spectrum of tools that a professional would also use to plan, construct and manage, and with respect to investment planning, this should also include tools needed to assess appropriateness of structure to liabilities and risk profile.

There is of course an intersection here with those who should not be managing their own assets and clearly online service sites should demarcate the fork in the road between a) manage your own with the help of tools and recommendations (clearly a regulated activity, b) manage your own with the tools but without the recommendations (quite probably not a regulated activity in terms of providing security recommendations, but regulated in the sense that constructs have to be appropriate and able to stand on their own) and c) have your assets managed remotely but with investor access for investment planning interaction and what ifs etc.  

The transaction module, which is what the OEO is essentially, is likely to be appended to more advanced wealth management service options in future.  It is time to look at the evolution of wealth management services in a technologically innovative world as the barriers to the provision of lower cost/sophisticated wealth management services come down.

Final Words

There are conflicts that need to be resolved between the face to face model and the online model, between the nature of investor responsibility for those with the intent and the tools to manage their own and those without. 

There is a conflict between a retail advisory model (in Canada) with high costs, suitability issues and imbalances in regulation of responsibility for decisions and process, and the development of the online medium which offers many investors a way out via better structure and lower costs.

The development of the online medium needs to be carefully managed and concerns over the impact of push on investors using these sites warrants serious attention, but the dimensions we are dealing with are more nuanced and wider than the push/pull of the traditional brokerage model, a model from which the discount brokerage rose from.

IIROC’s consultation seeks only to close down the options for DIY investors and makes no real attempt to look at the ways in which these sites can be developed to aid investors use tools and models safely and without undue influence, to help them better manage their portfolios.   

Globally the issue of model portfolios and Robo advisers and the impact of such on the traditional advice led model are being given serious consideration.  But in international jurisdictions the backdrop is also of a different order: best interest standards and the removal of embedded compensation have opened up the market place to more professional and higher standards of advice.  

Leave a Reply