Why portfolio funds aren't for everyone

Investor preferences and cost savings may outweigh convenience.

Rudy Luukko 7 August, 2018 | 5:00PM
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Fund dealers should encourage their employees to take a portfolio approach when making recommendations to investors. But there are right ways and wrong ways to go about it. The wrong way is illustrated by the Ontario Securities Commission's mid-June settlement with Royal Mutual Funds Inc., the primary distributor for the RBC family of funds. Royal was fined $1 million for providing financial incentives to some of its licensed staff to sell fund-of-funds portfolios instead of other options.

For nearly five years, starting in November 2011, Royal paid higher commissions to its investment and retirement planning (IRP) staff who sold RBC portfolio funds to their clients. These financial planners, who made up about 11% of Royal's total sales force, received 0.10% higher commissions for selling RBC "portfolio solutions" than for sales of other RBC funds and third-party funds that they were also authorized to sell.

What put Royal offside was a sales-practices rule that prohibits fund dealers that sell both proprietary and third-party funds from offering sales incentives favouring proprietary funds. In this instance, the incentives discriminated against not only third-party funds but also most RBC funds. The wider issue, which applies to all purveyors of portfolio funds, is to assess whether a fund of funds is in the best interests of an investor.

One tenth of a percentage point doesn't sound like much of a sales incentive. But it added up to a nice sweetener for Royal's financial planners. Over the five years, each planner received an average of between $4,848 and $6,282 a year as a reward for steering their clients into RBC portfolio funds, according to the OSC settlement agreement.

The higher commissions over five years totalled $24.5 million. This, in turn, translated into hundreds of millions of dollars in management fees for Royal's corporate sibling RBC Global Asset Management Inc., which manages the RBC funds. In that context, a $1-million fine seems like the big-business equivalent of a parking ticket.

According to the settlement agreement, Royal contends that a mitigating factor was that its compensation incentives were intended to encourage planners to recommend RBC portfolio funds, rather than to specifically discourage investment in third-party funds. Royal considered the portfolio funds to have distinct benefits for clients, "including diversification and active portfolio management."

Needless to say, RBC portfolio funds cannot claim exclusivity with regard to either of these product characteristics. But steering clients into its own portfolio funds undoubtedly provided benefits to Royal itself, as it does for other proprietary sales forces.

Compliance is simplified, since clients are matched with prepackaged portfolios that are suitable for their risk-return profiles. And as long as the salespeople determine that the client's objectives and risk tolerance are substantially unchanged, no further action is required.

The portfolio-fund holdings are rebalanced, as needed, by investment managers. Advisors who sell portfolio funds don't have to bother with obtaining client approval for rebalancing transactions, as they would for investors who held a portfolio of single-category, stand-alone funds. Besides, unless they botch the know-your-client process, salespeople aren't ever going to be fired for selling the house brand of portfolio funds.

Fund-of-funds portfolios represent the commoditization of the investment process. Advisors determine which prepackaged portfolio of fund of funds is the best fit for the client, and take care of them with just one buy order.

Even though Royal fell afoul of securities rules, fund portfolios generally meet with the approval of the regulators. In their sweeping package of proposed mutual-fund regulatory reforms released in late June, the Canadian Securities Administrators stated their intention to move away from trade-based suitability determination to one that is based on overall portfolio-level analysis. The regulators are also supportive of the new breed of online investment advisors, commonly known as robo-advisors, that use online questionnaires to place investors in suitable portfolios consisting primarily of low-fee exchange-traded funds.

The smaller the amount being invested, and the simpler the investor's financial situation, the more likely that a fund-of-funds portfolio will be suitable. But as the amount invested grows, and as financial-planning needs become more complex, investors should expect their advisors to look beyond off-the-rack, one-ticket solutions.

Here are some reasons why a more customized approach to building fund portfolios might be warranted:

Existing holdings: An investor who enters a new relationship with an advisor may very well already have holdings in other registered or non-registered accounts. These need to be factored into what makes sense in terms of an overall portfolio solution. If this situation applies to you, be sure to ask your advisor how these holdings -- whether they be equities, fixed income or some other asset class -- will be factored into their recommendation. If you are already invested heavily in Canadian equities, for instance, adding a broadly diversified portfolio may leave you uncomfortably overweight in Canada.

Active versus passive management: There are merits and disadvantages to both active and passive investment strategies. So it comes down to individual investor preferences, and it's up to you to communicate what you prefer. Index-based products are very likely to be cheaper if you're willing to be satisfied with market returns minus fees.

Fee discounts: Depending on a fund company's management-fee schedule, its fund-of-funds portfolios may not provide for reduced fees for larger accounts. But if your account size is in the six or seven figures, choose funds that will give you a break on fees. These discounts haven't always been applied fairly. Over the past four years the OSC has penalized some prominent advice-giving firms -- including Assante Capital Management, BMO Nesbitt Burns, CIBC Wood Gundy, Manulife Securities, Quadrus Investment Services, RBC Dominion Securities, ScotiaMcLeod and TD Waterhouse -- for failing to place clients in reduced-fee funds for which they were eligible. To avoid missing out, higher-net-worth investors should ask their advisor about what they can invest in to qualify for lower fees.

Non-core investments: Portfolio funds of funds generally do a good job of providing exposure to the core equity and fixed-income categories. But you as an individual investor might not be satisfied to stop there. Some investors might want to invest in broadly based funds, but that also have socially responsible investing (SRI) mandates. You might want to expand beyond core holdings, tilting your portfolio toward a particular sector or investment style, or diversifying with an alternative strategies fund.

Summing up, fund-of-funds portfolios and other "one-stop solutions" are popular choices for mass-market retail investors, and have some positive attributes. Among them: diversification, rebalancing, simplicity and convenience. But the decision to invest in these products should always be based on your own needs and circumstances, and not on what's best for the fund company or its salespeople.

Rudy Luukko has been commenting on the Canadian fund industry since 1990. A former newspaper columnist and Morningstar editor, he is now a freelance writer and regular contributor to Morningstar.ca. While Morningstar often agrees with what Rudy writes, his views are his own.

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About Author

Rudy Luukko

Rudy Luukko  Rudy Luukko is a freelance writer who contributes to Morningstar.ca on topics involving fund industry trends and regulatory issues. He retired in May 2018 from his position as editor, investment and personal finance, at Morningstar Canada, where he had worked since 2004. He has also worked as an editor and writer for various general, specialty and institutional media, and he has co-authored courses for the Canadian Securities Institute. Follow Rudy on Twitter: @RudyLuukko.

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