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Discontinuing embedded commissions: a win for investors

Trailer fees encourage advisors to serve the interests of fund companies instead of investors.

Christopher Davis 7 June, 2017 | 5:00PM
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Christopher Davis: Canadian regulators appear poised to change how advisors sell mutual funds. And that's a good thing.

Right now, most Canadians pay their advisors nothing up front, but in exchange, they pay higher management fees year after year. Fund companies pay a fixed portion of the higher management fee to mutual fund dealers in exchange for selling their funds.

Defenders of this status quo characterize these costs as a "fee for advice." But as compensation for goods sold, they fit the textbook definition of a sales commission. Morningstar believes regulators should outlaw these commissions, which are called embedded commissions or trailer fees, because they encourage advisors to serve the interests of fund companies instead of investors.

Fund companies naturally prefer to sell higher-cost funds because it means more revenues from fees. And they use commissions to steer advisors to funds with higher fees. For example, the commission paid for selling more expensive actively-managed funds is at least double the commission paid for selling cheaper passively-managed funds. No wonder index funds haven't gained as much traction in Canada as they have in other markets. In the US and Asia, for example, index fund market share is more than twice as high as in Canada.

We don't have to imagine what a world without embedded compensation looks like. The UK banned embedded commissions in December 2011. Since then, index funds' market share has doubled from 7% to 14%. And in Canada, the number of advisors selling funds without commissions has grown markedly over the past five years. Over this time, costs have fallen faster among funds sold without commissions. Without incentives to favour some funds over others, advisors pay more attention to investment quality, of which cost is an important indicator.

It's a reasonable to worry doing away with embedded compensation could make it harder for less-affluent investors to get advice. We think that advances in technology will serve this group well, however. So-called robo advisors offer sophisticated asset allocation services at relatively low cost.

By promoting competition, lowering costs and driving technological innovation, Morningstar believes discontinuing embedded commissions is a win for investors.

For Morningstar, I'm Christopher Davis.

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Christopher Davis

Christopher Davis  Christopher Davis is Director of Manager Research at Morningstar Canada.

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