Embedded fees policy on way

Study questions fee influence on mutual funds

TORON TO • A policy signalling whether Canada intends to ban embedded mutual fund fees is to be released in the first half of next year, more than three years after Canadian regulators began studying the issue.

The Canadian Securities Administrators, an umbrella group of the provincial sec urities regulators that has been studying mutual fund fees since 2012, released the time frame Thursday along with the latest research commissioned to look into the impact of embedded fees — sales and trailing commissions — that have become controversial in recent years.

Among the findings of the independent study, which was based on industry data, is that better-performing mutual funds attract more sales, but the influence of past performance is “considerably reduced” when fund manufacturers pay sales and trailing commissions.

The study also found that an increase in trailer fees corresponds to a decrease in performance.

As CIBC World Markets analysts Rob Sedran and Paul Holden put it: “There is nega- tive drift in fund performance when other factors, such as trailers, influence fund sales.”

The study found a different story for mutual fund sales through fee-based purchase options. In these cases, fund sales are highly influenced by past performance and this has a positive impact on future performance.

“The suggestion is that, yes, compensation does materially alter fund sales and, in some cases, to the detriment of investors,” said Monica Kowal, vice-chair of the Ontario Securities Commission.

She called the study, which looked at 11 years of fund sales across a broad swathe of the industry, unprecedented.

“Our goal at the OSC is to better align the interests of advisers and mutual fund managers with the interest of investors,” she said, adding the range of new policies under consideration includes a ban or cap on embedded fees.

Whatever regulators determine, Kowal said, the status quo is not an option. “We’re looking to achieve better outcomes for investors, and would look to move beyond the status quo,” she said.

Bans on embedded fees are already in place in other jurisdictions such as the United Kingdom.

Other policy options for Canada would include taking a “holistic approach focusing on the adviser-investor relationship in its entirety,” which could take the form of introducing a best-interest standard, Kowal said.

If a best-interest standard is adopted, advisers would be required to put their client’s interests first when choosing investments, rather than relying on the current standard of recommending investments that are simply “suitable.” Proponents of a best-interest standard say it would mitigate conflicts between where money is invested and adviser compensation.

Martin Wheatley, who was chief executive of the U.K.’s Financial Conduct Authority until July, recently told a Toronto audience that sales of “high margin” financial products for advisers fell to 20 per cent of the market from 60 per cent within three months of adopting client best-interest rules.

Kowal said a third option for Canada is to improve transparency and control over fund costs for investors by separating trailing commissions from fund management fees and changing how the different fees are disclosed.

Regulators will be digging deeper into the research as they formulate the new policy to be released by June, Kowal said, adding that there will then be a period of public comment and consultation with the investment industry and other interested parties.

Neil Gross, executive director of the Foundation for the Advancement of Investor Rights (FAIR Canada), said the findings should push regulators to act quickly. “It is clear that banning trailing commissions would be a very positive step for Canada,” he said. “We need healthy competition and Canadians are entitled to expect professional advice that’s not misaligned, that is not conflicted, and that serves their interests.”

The investment industry has resisted increased regulation of fees. Among the arguments is that advisers would be forced out of the business by the change in compensation, decreasing the availability of advice for retail investors. The Investment Industry Association of Canada has urged regulators to hold off on policy reforms, at least until the latest round that governs the “client relationship” is fully implemented in July.

As the debate about fees heated up over the past few years, mutual fund companies began to introduce new, lower-cost mutual fund options. On Thursday, TD Asset Management expanded its D-Series, which is a lowcost option for self-directed investors.

Atul Tiwari, managing director of Vanguard Investments Canada Inc., said the research confirms his preference for the fee-based model used by Vanguard. “There are a lot of good mutual fund managers, but the issue is it’s very difficult for them to beat the market given fees,” he said in an email. “Unfortunately, Canadians pay some of the highest mutual fund fees in the world.”

The new research follows a literature review published earlier this year that looked at the impact on investment outcomes of fee-based versus commission-based compensation. The report found funds that pay commission underperform.