Fund News

Discussion paper raises possibility of ban on embedded advisor compensation.
By Rudy Luukko | 13/12/12

In a controversial discussion paper released today on mutual-fund fees, the Canadian Securities Administrators (CSA) raised the possibility of banning trailer commissions and other embedded advisor compensation.

About the Author
Rudy Luukko is editor, investment and personal finance, at Morningstar Canada. Before joining Morningstar in 2004, he worked as an editor and writer for various general, specialty and institutional media. He holds a Canadian Investment Manager (CIM) designation and a Bachelor of Journalism degree from Carleton University. A former chair and founding member of the Canadian Investment Funds Standards Committee (CIFSC), he has also co-authored courses for the Canadian Securities Institute. He welcomes your comments at rudy.luukko@morningstar.com but cannot provide individual advice. Follow Rudy on Twitter: @RudyLuukko

Such a ban would shake the fund industry to its foundations, since trailer fees have grown to become an increasing portion of compensation for Canadian brokers and dealers who sell mutual funds. According to an Investor Economics study cited in the CSA paper, trailer commissions have grown to 64% of advisors' compensation from fund sales as of 2011, up from 27% in 1996. Typically, about half of the management fee that an advisor-sold fund collects is flowed through to the advisor.

But as the CSA study noted, there is a global trend among regulators toward addressing the conflicts of interest inherent in embedded compensation. In the United Kingdom, trailer fees will be banned, effective Jan.1, and in Australia a voluntary ban on trailers will become compulsory, effective July 1, 2013. In the United States, the proposed new 12b-2 rule proposed by the Securities and Exchange Commission, and now in the comment stage, would cap the amount of embedded compensation that could be charged and require further disclosure of such compensation in the trade confirmation at the time of purchase.

An outright ban on trailers is only one of a number of proposed reforms that the CSA has put forward. Other proposed regulatory alternatives include:

  • Requiring advisors to specify the services to be provided in exchange for trailer commissions. Under this option, advisors would be prohibited from collecting trailers if it could be determined that the services were not being provided.

  • Creating lower-fee classes of fund units or shares for do-it-yourself investors that would pay reduced trailer commissions or none at all. This could be made a requirement for all mutual funds that pay trailers to advisors.

  • Unbundling of the trailer commission from management fees and requiring it to be charged and disclosed as a separate asset-based fee. This would enhance the transparency of these fees and limit what they could be used for, the CSA paper said.

  • Separate series or classes of funds for each purchase option. Already a widespread practice in this industry, this could be made mandatory. One benefit would be that front-end-load purchasers would not subsidize the higher costs that fund companies incur on deferred-sales-charge sales, for which they pay upfront commissions to salespeople.

  • Capping of trailer commissions. Limits could be set on the portion of fund assets that could be used to pay trailers to advisors. Alternatively, a cap could be imposed on aggregate sales charges, meaning the sum of point-of-sale commissions and ongoing compensation.

  • Implementing additional standards or duties for advisors. To mitigate conflicts of interest, the CSA could impose new regulations imposing a duty on advisors to put their clients' best interest first. This would be more stringent than current requirements, which require recommended investments to be suitable but fall short of a fiduciary standard.

In reading the report, what emerges is a sense that the status quo on fund fees is not an option for the regulators, and that further measures will be implemented to address potential conflicts of interest. Despite the disclosure of embedded advisor compensation in the prospectus and the short-form Fund Facts document, the trend toward greater reliance on these fees has led many investors "to mistakenly believe there is no cost to purchasing or owning a mutual fund," the paper said.

The discussion paper cites investor surveys that show most investors have little or no idea of how advisors get paid. It also highlights that advisors are not required to tell investors about how much they make on trailer fees or other embedded compensation such as point-of-sale commissions they receive from fund companies for selling deferred-sales-charge funds.

In what amounts to a comprehensive and stinging critique of embedded commissions, the CSA points out that they limit the ability of fund investors to control or influence how much they pay for mutual funds. Trailer commissions can be increased without fundholder approval, and investors have no say in the extent to which their fees are used to pay for advisor compensation.

Nor, as the CSA observes, is there a "clear correlation" between the amount or rate of trailer commissions paid, and the level of service that salespeople provide in exchange for these commissions. For example, do-it-yourself clients of discount brokers typically hold the same trailer-fee-paying series of a fund as clients of full-service advisors.

The current trailer-fee structure, says the CSA paper, offers a one-size-fits-all approach that seems "potentially misaligned with the current practice of providing services tailored to an investor's personal circumstances, expectations and preferences."

Trailers create conflicts of interest for advisors in what to recommend to their clients, the paper says. Since trailer fees are higher for equity and balanced funds than for fixed-income funds, there's a financial incentive to tilt investor portfolios toward equities.

Likewise, trailers influence the choice between different providers and the choice of purchase option. The competition for advisor loyalty, through payment of embedded compensation, raises the perception that "mutual fund manufacturers may consider the advisor, rather than the investor, to be their customer, which could lead them to favour the needs of the advisor over the interests of the investors in their mutual funds."

Another source of conflict cited by the CSA is automatic conversion of fund units from one series to another. This involves deferred-sales-charge funds being converted to higher-trailer front-end-load series once an investor has held the fund long enough to redeem without penalty. The conversion frequently yields a 100% increase in trailer compensation for the advisor "without any consent from or disclosure to the client at the time of the conversion."

The full paper, entitled CSA Discussion Paper 81-407 Mutual Fund Fees, invites comment from industry participants, investor advocates, individual investors and other interested parties. The comment period closes four months from now, on April 12, 2013.

In releasing the report, Bill Rice, chair of the CSA and chair and CEO of the Alberta Securities Commission, cited the need to explore what else regulators need to do beyond its existing disclosure requirements for mutual funds: "It is important that we look at Canada's mutual-fund fee structure carefully in determining what changes could or should be considered to enhance investor protection and foster confidence in our market."

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