With Canadian securities regulators' policy decision on the fate of embedded fund commissions likely only a few days away, the big question is: Will they or won't they announce plans for an outright ban?
As has been well documented, trailer commissions and other embedded compensation create potential conflicts of interest between advisors and their clients and raise the costs of owning funds. And even with new annual disclosure requirements, embedded commissions remain less transparent than fee-based accounts that generally provide monthly disclosure. The United Kingdom and Australia have banned embedded commissions. Why not Canada?
The most common argument cited by opponents of a trailer-commission ban is that it would create an "advice gap" as advisors abandon small accounts that become uneconomic to serve under fee-based arrangements. However, I believe that gap would only be temporary, since small investors would still have access to multiple alternative providers of either the bricks-and-mortar or online variety.
A more fundamental reason why the regulators should be wary of eliminating embedded commissions altogether is the current state of fund competition in Canada. It's debatable whether it is in the public interest to impose policies that will result in further market-share gains for the Big Six domestic banks, given that the banks as a group already dominate the fund industry.
Assuming that a ban is imposed, Morningstar financial-services analysts Greggory Warren and Eric Compton say in a newly released research paper that the balance of power in the fund industry would continue to shift more and more toward the Big Six banks at the expense of non-bank-affiliated asset managers. "With more than 80% of fund assets in Canada held in commission-based accounts, a ban on trailer fees would push investors into fee-based account structures and put a much greater focus on management fees and investment performance, with the banks far better suited to compete on price than non-bank-affiliated firms," they write.
Collectively, the banks are not only among the biggest distributors of mutual funds in Canada, but are also some of the largest fund sponsors, led by RBC Global Asset Management and TD Asset Management. As the research paper notes, the Big Six increased their market share in mutual funds to 50%, up sharply from 34% a decade earlier. "While some of the banks' growth has been achieved via the acquisition of purer-play asset managers, like Scotiabank's 2010 purchase of DundeeWealth, the bulk of the increase in market share has come from organic growth, which a leveraging of the Canadian banks' extensive branch networks to sell product has driven."
As the Morningstar paper observes, a full ban on embedded commissions would have some favourable consequences. Since advisory services would be billed directly to investors, fund-company payouts would no longer influence advisors' recommendations. Lower-fee products, such as passively managed exchange-traded funds and the direct-sales mutual funds that pay no trailer commissions, would also no longer have to compete with products that pay (some would say bribe) brokers and dealers for doing business with them.
Even so, there's reason to believe that the consensus view of the Canadian Securities Administrators, representing regulators in all 10 provinces and three territories, would be to take a more moderate approach to addressing the issue. Most of what the opponents of embedded commissions would want to see is already happening because of market forces.
While full-service brokers typically turn up their noses at anything less than six-figure accounts, bank branches and the growing number of robo-advisors welcome small accounts with open arms. Assets of ETFs -- cheaper and unencumbered by trailers -- are growing at a far more rapid rate than traditional mutual funds.
As for advisor compensation models, market share is also shifting. Though fee-based distribution channels in three major asset classes accounted for less than 10% of fund assets, according to the Morningstar paper, their growth rate in recent years has been far greater than for commissioned channels. The policy issue, the Morningstar analysts note, is whether market forces are exerting enough of a push toward fee-based accounts. "With more than 80% of the Canadian retail market continuing to be serviced via commission-based structures, the issue of embedded trailer fees remains."
With or without trailers, active, independent fund managers that deliver good value to investors should be able to compete effectively with the banks. "There will always be room on third-party platforms for active fund managers that have a track record of good, repeatable investment performance and reasonable fees," Morningstar's Warren and Compton write.
But given the propensity of banks to favour their own proprietary fund products and to cross-sell other products and services, is it necessary for the regulators to be a heavy-handed market disruptor of business models by banning all embedded commissions? Since public-opinion research has found that a majority of fund investors prefer bundled advice, banning this practice would seem to be regulatory overkill in a competitive marketplace. A complete ban would have the effect of increasing the banks' dominance and weakening the ability of independent fund companies to compete on performance, product innovation and value-added services.
As for fund distributors, bank-owned entities are well represented among the firms that have agreed to multi-million-dollar settlements for overcharging investors. The point here is that investors are better off if the Big Six face strong competition to do the right thing for investors, rather than being handed more market clout as a result of regulatory intervention.
This is not to say that the marketplace doesn't need help in addressing unfair sales practices and price gouging by brokers and dealers. As the regulators have stated repeatedly, the status quo on embedded commissions is not an option. But instead of an outright ban, regulators could instead prohibit two well established practices that are the most prone to abuse. One is the deferred-sales-charge (DSC) purchase option. The other is the unjustified revenue windfall for no-advice discount brokers that collect full-service trailer commissions.
Point-of-sale DSC payouts of 5% to dealers are clearly excessive under today's market conditions of single-digit investment returns and with nearly all dealers setting their front-end loads at zero. Since it made its debut in 1987, the DSC option has had the seductive aspect of purportedly allowing investors to put all their investment to work from Day 1.
This is illusory, since the cost of DSC upfront commissions is built into the funds' management fees. And while trailer commissions may be only half of what dealers receive on front-end-load sales, redemption fees that take six or seven years to disappear may leave investors effectively trapped in a fund if they conclude that they'd be better off elsewhere. Also, for funds that have multiple purchase options within a single series, investors who choose the front-end-load option are subsidizing the DSC option. For all these reasons, the DSC is a prime target for a regulatory ban.
Even more deserving of a ban is the practice of allowing order-execution-only discount brokers -- which are not permitted to give advice -- from collecting full-service trailer commissions. The Investment Industry Regulatory Organization of Canada (IIROC), the self-regulatory organization for the brokerage industry, has called on discounters to address what it describes as compensation-related conflicts.
What IIROC hasn't done, and what regulators should have no hesitation in doing, is putting a halt to the long-standing practice of enabling discounters, most of which are bank-owned, to in effect charge self-directed investors for advice that they aren't giving. We should soon find out where the regulators stand on this and many other investor-protection issues, since multiple sources say the CSA's decision on embedded commissions and other proposed reforms is to be released on June 21.
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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