Cost isn't everything when it comes to gauging the value of advice that Canadian investors receive when buying mutual funds. Of crucial importance is the quality of that advice, particularly when it's the fund company -- not the investor -- that is paying the advisor.
Unlike in the U.S., where advisors generally charge their clients directly, the cost of advice for fund investors in Canada is usually embedded in the management fees of the funds. Given this prevailing practice, investors need to consider the independence and objectivity of the advice that they receive.
Vertical integration is prevalent in the Canadian financial-services industry. Many Canadian advisors are "captive" employees of fund companies. These advisors may be restricted to only those funds that are sponsored by their employer.
The most obvious example is Investors Group, whose sales force can offer only the firm's proprietary funds, including a limited selection of co-branded products. Among the others who face similar restrictions are advisors who work for the banks.
When dealing with a captive or semi-captive advisor, investors should consider factors that may compromise the objectivity of the advice that they receive. Asset-allocation advice and other big-picture items may be well-conceived. But is your advisor putting you into second- or third-rate funds within that asset-allocation framework, given the very limited selection available?
By contrast, in a fee-based advisory relationship, the client pays fees directly to the advisor in return for objective advice. Moreover, the fees are negotiable and are agreed upon at the start of the relationship.
Over the past two decades in the U.S., the fee-based model has steadily grown to become the most popular advisor-client relationship. In Canada, however, fee-based advisors are still a small minority.
The issue at hand here is open versus closed architecture. An open-architecture platform is the most investor-friendly. It allows advisors to select the funds based on their suitability and merit, not on the basis of whether the funds' branding name matches the one on their business card.
The prevalence of the open-architecture platform in the U.S. has helped the fund industry there to evolve into a meritocracy. The advisor works for the client, so it makes sense that the client pays the advisor to ensure they act in their best interest. The idea is to align the interests of the client with those of the advisor.
In Canada, however, firms with the most powerful distribution networks dominate the market. When the fund companies are compensating advisors to put investors into their funds, it raises the potential for conflicts of interest. What if a fund from Company A is more suitable for a client than a fund from Company B, but Company B will pay the advisor a bigger trailer fee? The advisor may choose the fund that pays him the most, rather than the one that would be in the best interest of his client.
For the do-it-yourself (DIY) investor who wants to keep costs low, a potentially great alternative would be F-class shares, which strip out any embedded advisor compensation. However, DIY investors cannot access these funds because they are available only through advisor-managed fee-based accounts.
DIY investors are at a serious disadvantage in Canada. Those who do end up buying mutual funds through discount brokerages are likely to be stuck paying the trailer fee (and therefore an excessively high management-expense ratio) while receiving no advice in return. Discount brokerages collect handsome trailer fees for simply taking orders.
High mutual-fund fees resulting from embedded trailer fees have been a big reason why exchange-traded funds have experienced impressive growth in Canada. ETFs enable investors to avoid paying embedded fees for advice that they don't care to receive. Anyone with a discount-brokerage account has access to low-cost ETFs. Or, for ETF investors who need advice, there's no conflict of interest in terms of how advisors get paid.