Why hasn't indexing taken root in Canada?

Big banks, incentives and self-regulators are to blame.

Christopher Davis 23 November, 2016 | 6:00PM
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If the Wall Street Journal is to be believed, stock picking is a dying business. Active managers still oversee 66% of U.S. long-term industry assets; however, a decade ago that market share was 84%.

Ominously, investors continue to vote against active management with their feet, even amid healthy market performance: While US$1.3 trillion gushed into passive investments for the three years to the end of September 2016, US$84 billion flowed out of active strategies. Active management isn't dead yet, but passive alternatives are clearly ascendant.

If the spectre of death looms over U.S. active managers, their Canadian counterparts have only begun feeling mild aches and pains. Passive investments have enjoyed healthy growth -- driven almost entirely by exchange-traded funds -- but actively managed funds continue to rake in greater sums. ETFs in Canada have nibbled at active managers' market share over the past decade, but they still hold less than 10% of industry assets, while the share of active investments has fallen precipitously in the U.S. in recent years.

Same afflictions, different outcomes

Many conditions the Journal article attributes to indexing's U.S. success -- discontent with long-term performance and high fees -- also ring true in Canada, if not more so. Actively managed Canadian funds have hardly been more successful than their U.S. counterparts in outpacing broad market benchmarks. For instance, as of September 2016, fewer than 20% of funds in the Canadian Equity category that were around 10 years earlier had survived and outperformed the S&P/TSX Capped Composite Index over that period. One big reason why: Canadian fund expenses rank among the highest on the planet, giving active managers a high hurdle to surmount.

When the mid-2000s energy boom led to soaring stock prices, high fund costs were easier for Canadians to stomach. Likewise, U.S. investors worried little about fees in the 1980s and 1990s as stock markets consistently delivered double-digit returns. After middling market performance in the 2000s, not to mention the trauma of the 2008 financial crisis, the move to passive investments accelerated.

Canadian fund industry observers commonly attribute indexing's failure to take root to its advice-driven market. This may explain why the indexing wave got a head start in the U.S. -- it was do-it-yourselfers who drove its ascent in the 1990s -- but it doesn't explain why indexed assets accelerated as advisors and other intermediaries gained increasing control of investment decision-making in recent years.

Despite the clear virtues of passive management -- not to mention a robust ETF industry eager to provide alternatives to high-cost active funds -- traditional active managers have been able to resist the tide thanks to market and regulatory factors that have historically favoured their interests. The tide could be turning, however.

Those with market power have made the rules

With market power concentrated in just a handful of market players, Canadian asset managers tend to compete more on the breadth of their investment offerings and distribution muscle. This competitive dynamic stacks the deck against ETF providers and other would-be market entrants, who are dependent on third parties for distribution.

That's not a problem for Canada's six largest banks, which have successfully used their built-in distribution network of bank branches to sell in-house funds. The banks control an increasingly large slice of long-term mutual fund assets. According to Morningstar data, the banks' combined share rose from 39% at the end of 2011 to 48% by September 2016. (Investors Group, which controls 7% of long-term fund assets, uses a distribution model similar to the banks, selling only funds with its house label through its giant national network of advisors.)

These funds are almost always actively managed strategies. TD distributes moderately priced index options to customers of its online brokerage, but none through bank branches. Other bank-run asset managers include index fund options in their lineups but they are limited in scope and high in price, at least by the passive management standards. Even BMO, the country's second-largest ETF provider, wraps its moderately-priced ETFs in high-priced mutual funds before selling them at bank branches.

The bank-run index funds are no bargain from the investor perspective but they still translate into lower management fee revenue for the advisor. No wonder they've ended up in few investors' hands: Excluding TD's Emerald funds, which are geared to institutional investors, indexed assets account for just 2% of the bank-run fund total. And among 150-plus Investors Group offerings, not one is an index fund.

To be sure, independent fund providers like Fidelity and CI Investments have been successful without controlling the pipes by which their products flow. This isn't to say they don't have distribution advantages of their own. The deep relationships they've built with advisors took years to develop and would be difficult for upstarts to replicate, insulating them from the competitive pressures posed by ETFs or other low-cost providers. Some have also built advisor networks of their own, as CI has with its subsidiary Assante Wealth Management, which it acquired in 2003.

It's the incentives, stupid

The same fund companies that have little incentive to offer index funds have given advisors little reason to use them. Paying advisors far larger commissions to sell clients active funds tilts the field against index funds. The commissions, which are built into the management-expense ratio (MER) and are commonly known as trailer fees, generally add another percentage point to the management fees paid to active stock funds but add half that amount (or less) to the price tag of index funds. (Commission-based series from ETF providers like iShares, PowerShares and Purpose Investments, which have 1% trailer fees, are an exception.) The commission-based business model is on the decline, but historically fund companies have paid advisors to sell costlier funds, and they've gotten their wish.

Regulatory roadblocks

There's another reason why many advisors don't put their clients in cheap ETFs: They can't. The Mutual Fund Dealers Association (MFDA) -- the self-regulatory organization overseeing 95 dealers that represent more than 80,000 advisors and nearly $500 billion in investor assets -- doesn't expressly forbid its members to trade ETFs, but few can do so. The MFDA (understandably) requires advisors to have met minimum educational standards before selling ETFs, but it has yet to issue long-promised proficiency requirements. (A comment period on these standards ended in September.) Even when this hurdle is out of the way, most dealers won't have the operational capabilities to trade ETFs. Quite amazingly, more than 25 years after the world's first listed ETF launched in Toronto, a better part of the country's advisors still can't touch them.

Change in the air

The threat Canadian active managers have faced from passive rivals has been modest thus far, but the warning signs of a coming storm are there.

As advisors increasingly move to fee-based business models, commission-driven decision-making should fade away. Canadian regulators have given the invisible hand of the market a helping hand, though. In July, they required advisors to begin disclosing to clients their fees in dollar terms and returns in dollar-weighted terms. These rules, known as phase 2 of the Client Relationship Model (CRM2), don't require fund companies to disclose investment management costs in dollars, which make up the lion's share of the MER.

The regulations (rightly) pressure advisors to prove their worth to clients, but they don't ask the same of investment managers -- at least not directly. I'd expect some advisors to demonstrate their value by shifting to low-cost investments, the benefit of which should shine through in higher returns. Asset managers tell us the regulations have accelerated the trend from commission-based to fee-based advice, the latter being more amenable to passive management for reasons discussed above. As a roundabout nudge toward passive management, CRM2 looks more like a force for gradual change.

Canadian regulators are also considering new rules that could give it a push. Outlawing embedded trailing commissions -- an outcome the Canadian Securities Administrators (CSA) seem to want -- would tear down one of the largest structural impediments to the spread of ETFs and other low-cost investments. After the United Kingdom banned trailing commissions in 2012, the trickle into passive funds turned into a flood. As Morningstar equity analyst Michael Wong noted in October 2015, passively managed UK assets increased approximately 140% from 2011 to June 2015, and market share significantly increased from about 7.4% to over 12%.

Along with doing away with embedded trailers, the UK also introduced a best-interest standard -- another step under review by the CSA. As the name implies, this requires advisors to act in their clients' best interests and would likely tilt the field in favour of passive management. Under the lesser "suitability" standard that currently governs advisors, it's acceptable to sell a high-priced fund with middling performance as long it's aligned with the client's financial situation and risk tolerance. Advisors need not avoid conflicts of interest, such as selling products that pay higher commissions, as long as they're disclosed. The best-interest standard obliges advisors to avoid conflicts of interest and choose investments with reasonable fees. This higher standard doesn't limit advisors to passive investments, nor should it. But lower costs and above-average historical performance are easier for advisors to defend.

Critics of regulatory change argue (with some justification) ditching embedding trailers could make it uneconomical for advisors to service clients with smaller accounts. Automated services such as robo-advisors could fill the void and give passive funds a boost. There's no rule against robo-advised portfolios holding actively managed funds, but the reality is they don't. Canadian robo-advisors like BMO, Wealthsimple, Nest Wealth and Questrade build portfolios using ETFs. Some rely on market-cap-weighted strategies entirely, while others mix them with strategic beta ETFs.

The end will come, either with a whimper or a bang

To be sure, it's possible active management as it currently exists may have plenty of life left. The U.S. experience is a natural point of comparison for Canadians, but there's no natural law of physics requiring Canada to follow America's lead. There appear to be global forces at play Canadian asset managers cannot resist forever, but they could hold them off for a while longer. Banning trailer fees and implementing a best-interest standard have been long discussed by regulators, but it's possible this slow-moving process will grind to a halt. Change would come more slowly as a result, but no matter the speed, the future looks more investor-friendly than ever.

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Christopher Davis

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

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