INVESTING 2014

CANADIANRETAIL INVESTORS HAVEADEARTHOFCHOICESWHENITCOMES TORECEIVING AFFORDABLEANDGOODFINANCIALADVICE, BUTADVOCATESAREPUSHINGFORMORE DISCLOSURE ANDBETTERJUDGEMENT. THEINDUSTRYIS PUSHINGBACKBYDAVID PETT

IN MUTUAL FUNDS WE TRUST

Canadians still love them, but the affair is ending

CALL OF DUTY

Why retail investors aren't getting the best from the industry

INVEST LIKE THE RICH

How investors can start thinking like a millionaire

Tom Bradley walked into the B.C. Securities Commission in downtown Vancouver ready to ruffle some feathers at one of several roundtable discussions on mutual fund fees being held around the country last June. The veteran money manager and president of Steadyhand Investment Funds believes the current fee structure in Canada needs improving and knew this view would clash with that of many of the other investment dealers in attendance. But when all was said and done that day, even he was surprised by the sheer opposition to his arguments. “It was about 15 or 16 people and I guess there was a little tension, but without me there it would have been a love-in,” he recalls. “We had some good battles, but it was like everything in the industry was wonderful.”

The reality, however, couldn’t be further from the truth, Bradley says. Some of the country’s most powerful industry participants, including the major banks and largest mutual fund manufacturers, continue to believe in the status quo, but he and a growing group of others believe the current framework governing financial advice in Canada is broken and they’re arguing that further changes are necessary to ensure the best interests of investors are being served. “It’s urgent, that’s why I have been so vocal about it,” Bradley says. “We

have a pension crisis heading at us and clients are not doing very well. Part of it is fees, but part of it just shoddy advice. The longer we kick the can down the road, the worse it’s going to get.”

The idea that advice given by financial managers is not up to snuff is hardly new, but in recent years it has taken on far greater importance. There’s no question the financial crisis is partly responsible for this. After all, when markets collapse, as they did in the fall of 2008, investors would be remiss not to reconsider the value of the advice they’ve been given. But other factors are also at play, including a far more complex marketplace for financial products and services and an aging population that is focused more than ever on finding ways to build a sustainable nest egg for retirement. Altogether, it’s put a premium on financial advice, but also exposed it to criticism on several fronts — including best interest obligations, remuneration and minimum proficiency requirements — which has prompted a wave of regulatory reforms and proposals around the world.

In Australia, a statutory best interest duty has been imposed on advisors who sell financial products, while regulators in the United Kingdomrecently banned advisor commissions set by financial product providers or embedded in financial products. Similar reforms are being considered in Europe and the United States. In Canada, the Canadian Securities Administrators ( CSA), whose members are the provincial securities regulators, is taking notice of many of these issues as well. CSA initiatives include new point-of-sale disclosures for mutual funds, and cost disclosure and performance reporting for advisors. These reforms, while not fully implemented yet, will mandate a description of charges that the client might pay in the course of holding an investment, including trailing commissions, as well as an annual summary of charges incurred by the client and all the compensation received by the registered firm that relates to the account.

In addition, the CSA at the end of 2012 published two discussion papers hoping for feedback on two key topics: the appropriateness of

introducing a statutory best interest duty when advice is provided to retail clients; and the mutual fund fee structure in Canada. The former paper released in October of that year outlined the current standard of conduct for advisors in Canada and identified key concerns related to it, while also reviewing the potential benefits and costs of imposing a statutory best interest standard.

Currently, a fiduciary duty applies to advisors in some but not all cases. For instance, a portfolio manager who advises others on the buying or selling of securities and has discretion over a client’s investments must act in the client’s best interests as per common law. But a mutual fund advisor or dealer may not. Instead, they are generally bound by suitability obligations and must collect know-your-client ( KYC) information prior to making a recommendation, or accepting an instruction from a client to buy or sell a security. They may also be required to assess suitability following a transfer or deposit of securities into the account, when there is a change of representatives in the account, and/or a material change to the KYCinformation occurs.

Since the report was published, the CSA has heard from dozens of stakeholders, including investors, investor advocates, advisors, industry advocates, academics, law firms and professional associations, all of which revealed a significant disagreement about whether the current regulatory framework protects investors and what regulatory response is required, according to a status report published in December last year.

Proponents of a statutory best interest standard believe current regulations do not adequately protect investors, chiefly because the suitability standard currently in place requires an advisor to recommend products that match the general needs of the client, but not necessarily the product that is in the client’s best interest. At least anecdotally, this practice has become standard fare across the industry. For example, an advisor working at major bank branch recently told a client that a portfolio of exchange-traded funds is a way riskier strategy than using the mutual funds he sells. Part of his reasoning? The

ETF industry is still relatively new in Canada and there is a risk that it could suddenly backfire. He also added that mutual funds can give better returns than ETFs if you cash out at the right time. Both assertions are fairly ridiculous.

But those who support the introduction of a statutory fiduciary duty don’t stop there. They believe targeted regulatory responses are also required in several specific areas including job titles, which often blur the line between advice and sales, and proficiency requirements for advisors who are trained enough to sell in-house funds and products but may not know whether they are truly beneficial to clients.

The biggest concern, however, is related to advisor compensation. In its discussion paper on mutual fund fees, the CSA noted a gradual shift in the Canadian mutual fund market away from transaction-based sales commissions paid directly by investors to trailing commissions and sales commissions funded from, and embedded in, mutual fund management fees. This has led many investors to believe there is no cost to purchasing or owning a mutual fund — a falsehood exacerbated by a lack of disclosure by advisors. Only 64% of investors were told about fund costs before their advisors asked them to buy, concluded a 2012 study by the Investor Education Fund, while just 45% of investors said their advisors told them how much compensation they will receive.

As a result, many investor advocates believe embedded advisor compensation allows advisors to make investment recommendations that pay them higher compensation, often to the detriment of their clients. Most of these same people believe new disclosure requirements are inadequate in dealing with this conflict of interest and suggest an outright ban on embedded compensation or, at the very least, a fee structure that provides a true choice not to pay embedded commissions.

Peter Jarvis, CEO of CFA Society Toronto, said the mis-selling of investment products and services is an important issue in Canada that is eroding investor trust in the country’s advisory community. He said it’s common for advisors to recommend highfee products over lower-fee options, and inhouse products over other options that may be more suitable. “It wouldn’t take that long or be that hard to find examples of people who have been sold products that are higher fee than required to get the return stream they are looking for,” he says.