Winds of regulatory change favour ETFs

Morningstar Executive Forum panellists cite impact of greater fee disclosure.

Ashley Redmond 9 March, 2015 | 5:00PM

Note: This article is part of Morningstar's March 2015 ETF Investing Week special report.

The sense of excitement surrounding upcoming regulatory changes was palpable at the Morningstar Executive Forum on exchange-traded funds held in Vancouver on March 4.

The panel discussion featured Mark Neill of RBC Global Asset Management Inc., who is head of RBC ETFs and president of direct mutual-fund seller PH&N Investment Services; Susanne Alexandor, managing director and head of wealth management at Cougar Global Investments; and Atul Tiwari, managing director at Vanguard Investments Canada Inc., which sponsors the Vanguard family of ETFs listed on the Toronto Stock Exchange. All three agreed that improved disclosure of the costs of investing, and potential restrictions on embedded mutual-fund compensation, will stimulate the growth of ETFs and benefit investors.

The current major regulatory catalyst is the Client Relationship Model, Phase 2 (CRM2), which is being phased in over a two-year period that started last July. CRM2 imposes new requirements for reporting to clients the cost and performance of their investments.

The greater transparency that CRM2 will bring is expected to increase the market share of fee-based advisors and portfolio managers, and improve investor awareness of low-fee ETFs. Cougar's Alexandor, whose firm manages portfolios of ETFs using tactical asset allocation, said CRM2 is a good thing for investors because they will know exactly what they are paying for fund ownership.

Alexandor said fee-based advisors were at the root of ETF growth in the United States. Thanks to these advisors, she added, there were greater distribution opportunities for ETFs through traditional banks and brokerages. "Now with CRM2 we will hopefully see that happening here."

Meanwhile, the Ontario Securities Commission (OSC) is about a year away from releasing its position on fund compensation to distributors that is embedded in management fees. The most common form of direct compensation to fund salespeople is trailer fees, which are ongoing payments made to dealers for as long as investors continue to hold the funds. (Canadian-listed ETFs are available without having to pay embedded compensation, though several firms also offer "advisor-class" ETFs that pay trailer fees.)

One possibility is that the OSC, which is taking the lead role among securities regulators across the country on the fund-fee issue, will come down in favour of a complete ban on trailer fees. That position would be strongly opposed by the traditional mutual fund industry but generally welcomed by ETF companies. "If we see a ban on embedded commissions then ETF growth will shoot up," Tiwari said. "It will cause advisors to use lower-fee products like ETFs for their clients' portfolios."

RBC's Neill added that Canadian investors are becoming more educated on the importance of fees and the various fund structures that are available. He said a combination of that, along with any regulatory change, will bolster the ETF industry's growth.

In yet other regulatory development, Neill and Tiwari both said they expect the Mutual Fund Dealers Association of Canada (MFDA) to announce measures that will enable fund dealers to trade ETFs. This will give the ETF industry access to a large new group of distributors. (As one small Ontario dealer has shown, it's already legal for fund dealers to offer ETFs, subject to meeting back-office and proficiency requirements.)

Opinion was sharply divided at the Vancouver panel in response to a question from the floor on whether the number of ETF providers will increase in Canada. Neill predicted that the number may go lower before it goes higher because of competitive forces. He said a lot of mutual-fund players are facing challenges because of the upcoming regulatory changes and are therefore under more sales pressure. "I wouldn't be surprised if many of those organizations are taking a good look on whether or not to enter the ETF market with their own offering."

Taking an opposing, bullish view was Tiwari. "I think that five years from now, every bank will likely have an ETF platform." He added that if the banks don't enter the ETF space soon they will be kicking themselves. He also expects a few life-insurance companies to get in on ETFs, as well as independent mutual-fund managers through actively managed ETFs. "That's how those managers will get their toes wet."

Panel moderator Christopher Davis, director of manager research for Morningstar Canada, asked whether there was still room for innovation with ETFs. Alexandor predicted there will be more country-based ETFs. As long as there is underlying liquidity in the capital markets, she said, there is likely to be an ETF listing. She noted by way of examples that there are now ETFs that invest in Mexico and in South Korea.

Tiwari, whose firm tends to shun country-specific ETFs investing in smaller markets, predicts that the most popular types will continue to be traditional ones that track broad market benchmarks. "Of course it's exciting to talk about strategic beta, and there will be new products in that area," he said. "But you need to look at flows, and most flows go to straight market-cap-weighted ETFs."

For his part, Neill came down on the side of innovative offerings. He said that when RBC entered the ETF market in September 2011 with eight target-maturity corporate bond ETFs, the company asked investors and advisors what they needed from ETFs. "We got a request for products that were more forward-looking, as opposed to rear-view looking that tried to subtly improve on market-cap indexes."

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Ashley Redmond

Ashley Redmond  Ashley Redmond is a Vancouver-based freelance writer.