Fund Investing

Some countries say no.
By Steven G. Kelman | 13/08/10

Who should pay financial advisors -- the client, or the mutual fund or insurance company that makes the investment product? Apparently the regulators in Australia and the United Kingdom seem to think that point-of-sale commissions and trailer commissions paid to advisors distort consumer outcomes and should be banned.

About the Author
Steven G. Kelman is president of Steven G. Kelman & Associates Limited. His company provides specialty publications and training for the mutual fund industries. Steven is the author of several personal finance books and is author or co-author of courses offered by the Investment Funds Institute of Canada, including the Ethical Conduct and Behaviour continuing education course and the Labour-Sponsored Investment Funds course. He received a B.Sc. from McMaster University, an MBA from York University and holds a Chartered Financial Analyst designation.

 In the UK firms will have to describe their advice as either "independent" or "restricted" depending on whether they are able to provide a client with unbiased advice on the full range of products. Moreover, when new rules come into effect toward the end of 2012, UK firms that give investment advice to retail clients will be prohibited from receiving commissions from product providers for recommending their products.

 Australia's rules, which go into effect July 1, 2012, include a ban on commissions including trailer commissions and any form of volume-based payments.

So the way things will work in the UK and Australia is that advisors will be paid on a fee-for-service basis, charging the client a percentage of the assets under administration or an hourly fee.

Of course many Canadian financial planners already operate on a fee-for-service basis, as do investment counsellors. Some investment dealers offer a fee-for-service option for larger investors. Even mutual fund companies offer classes of funds -- known as F-class -- that don't pay trailers and are designed for investors who pay fee-for-service.

But the vast majority of buyers of mutual funds and segregated funds pay either a commission to their advisor at the time of purchase (known as a front-end load) based on a percentage of the amount invested, or they pay a redemption fee to the fund company if they redeem within a certain number of years (back-end load). In the latter case, the fund company paid a commission to the selling dealer.

In addition, for funds sold under either front-end or back-end load, the fund company will pay the advisor an annual trailer commission that is generally 0.5% to 1% of assets on equity funds. This trailer commission is paid for as long as the investor holds the fund and is bundled into the fund's management-expense ratio paid by the investor.

Australia plans to introduce a statutory fiduciary duty for financial advisors requiring them to act in the best interests of their retail clients and to place the interests of their retail clients ahead of their own. I'm sure many Canadian investors assume that their advisors have comparable fiduciary duties to them, but I'll bet some lawyers will argue otherwise, pointing out that much depends on how dependent the client is on the advisor for advice.

Australia has one provision that would cause some Canadian advisors to lose sleep at night because it could cut into their incomes drastically if introduced here. Australia will prohibit the charging of percentage-based fees on assets bought with leverage. The authorities of that country state this measure targets conflicts of interest where an advisor is "incentivized to recommend leverage to increase funds under management and hence fees." The practice in Canada has been to require disclosure of the risks of using borrowed funds to invest. Also, the suitability of leverage for a specific client is something that Canadian advisors are supposed to consider.

Canada, of course, is very different from Australia and the UK. Toronto securities lawyer Glorianne Stromberg's 1995 report to the Ontario Securities Commission, titled Regulatory Strategies for the Mid-90s -- Recommendations for Regulating Investment Funds in Canada, had a major impact on the way advisors were compensated. Her report resulted first in a new sales code for IFIC member firms. Subsequently in 1998 the Canadian Securities Administrators issued National Instrument 81-105: Mutual Fund Sales Practices, which ended what many in the industry considered improper sales practices.

Basically NI 81-105 banned such incentives as educational conferences in tourist hotspots that were based on sales levels of specific funds or fund families, cash for office furniture and other financial assistance, and kickbacks of commissions based on portfolio transactions stemming from an advisor's sales of mutual funds.

Even before the Stromberg report the industry had made changes. The old practice of selling mutual funds with a fixed 9% front-end load of which two percentage points was used to finance sales incentives started to disappear in the 1980s. More than a decade earlier the contractual mutual funds sales plans that required monthly deposits disappeared. The problem with these was that if investors cashed in their plans prematurely they would discover that about 50% of their first year's deposits had been paid as commissions and weren't refundable.

I'm sure Canadian advisors will be watching what happens in Australia and the UK with interest in the years following the ban on commissions to see what the unintended consequences are. Particularly, who will want to service investors with relatively small amounts of money to invest? I doubt if the individual with only a few thousand dollars will be willing to pay for a detailed financial review.

Conversely, I doubt if many experienced advisors will be able to afford the luxury of dealing with small investors who may or may not become long-term clients with substantial assets.

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