Fee disclosure presents client risk

Is your adviser set up to handle shift to ETFs?

Countries such as the U. K. and Australia have made real progress towards protecting investors, but the Canadian investment industry has been very reluctant to embrace changes such as adopting a legal fiduciary duty to act in a client’s best interest and it is also actively pushing back against disclosing fees.

Imposing one without the other, however, causes some unintended consequences and reshapes the landscape of what is now being sold to investors.

For example, brokers and advisers have quickly responded to the new disclosure requirements by dumping higher-fee mutual funds at a record pace and moving to low-cost exchange-traded funds in order to protect their margins while lowering the total fee being paid by the client.

Being a very active user of ETFs, we certainly recognize their merits as well as risks, and we worry when fees become the primary motivating factor to reshape a client’s entire investment portfolio — more so now since there is greater responsibility being placed on brokers and advisers to manage a client’s portfolio risk.

The question is: Do they have that expertise if they don’t have the qualifications or the intent to adopt a fiduciary duty?

Let’s say an adviser simply placed clients with an average risk profile into an F-class or low- fee balanced fund. A good balanced fund manager will de-risk the portfolio during market highs by adjusting the weightings between stocks and bonds, moving between sectors or using other methods.

This role is now being taken over by advisers, who may not have the depth of knowledge, expertise or even the time to do this for every single one of their clients, especially considering the average adviser has hundreds of them.

ETF providers also often bring on new products at the wrong time simply to feed the demand of advisers who find it much easier to sell recent performance. As a result, clients may have a portfolio filled with the hottest ETFs and not necessarily one that matches their overall risk profile.

In addition, there is the risk associated with properly navigating through the thousands of ETFs out there with different features that can be complicated. Some are levered so that they offer two to three times the expected exposure, others may not track long-term performance due to the problem of rolling contracts in the futures market, while some have liquidity issues and a high bid/ask spread so it is more costly to get in and out of a position.

A lot of the potential fallout from the move to ETFs will be flushed out during a market correction, but investors should not wait until then, especially if their entire portfolio is currently being switched to ETFs.

Investors should ask if their adviser has a legal fiduciary duty on their portfolio as well as an investment policy statement that specifically outlines how they are going to manage asset allocations.

For advisers who don’t have both, ask if their riskmanagement strategy is backstopped by a long- term track record of doing so with ETF portfolios.

Some ETF providers can offer this service on behalf of advisers via managed programs, which can be a good alternative. In this case, investors may want to ask why the majority of the fees are still being paid to the adviser.

We tend to be more agnostic in our approach between passive and active strategies, preferring more active management during market highs and passive ETFs during market lows. We also like ETFs in very large and efficient markets such as the U. S. and see greater value in stock picking in smaller and less efficient markets like Canada.

The good news is that the cost of active management is falling, making it more affordable. It may mean your broker is taking a cut on margins, but it also means acting in your best interest, which is usually a good thing.