Client Focused Reforms Part 3: Suitability

Today we focus on ‘Suitability Determination‘.

Ian Tam, CFA 9 February, 2021 | 1:01AM
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The Canadian Securities Administrators (CSA) have worked on a broad, sweeping set of changes to regulation designed to better the experience of the investor. The changes in regulation, which touch on some of the same areas as Regulation Best Interest changes in the U.S., came into effect in December 2019. Firms and advisors have until the end of this year to implement the processes required to adhere to the new regulations.

This series is aimed at helping you better understand the regulations, and how to best prepare for the changes. So far, we’ve talked about upcoming regulatory changes around the Know Your Client (KYC) requirement, and the Know Your Product (KYP) requirement. Today, we delve into the Suitability determination which ties the first two parts together.

Though we are looking at different parts of the regulation in isolation, know that they are designed to fit together. The regulations were created to set a minimum standard for advisors to follow with the intent to improve the quality of advice given to Canadians. A good advisor is may already be meeting these requirements, but perhaps not formalizing and documenting all the parts, which is now required.

Here’s what the regulations say advisors must do in terms of making a suitability determination, and why this is important to you as an investor:

Requirement: Before making a recommendation, advisor must have completed and documented all steps related to the Know Your Client and Know Your Product requirements.
Why Should I Care? To make a reasonable recommendation on your investments, of course the advisor must know you as an investor. The KYC portion of the regulation ensures that they accurately document your risk tolerance (attitude toward risk), risk capacity (financial ability to withstand losses), and investment time horizon. This information coupled with a required knowledge on a range of investment products will help ensure a reasonable recommendation is made.

Requirement: The advisor must assess the impact of a recommendation on your account(s) including concentration risk and liquidity.
Why Should I Care?
An example of potential concentration risk is when you own multiple mutual funds and ETFs in your account each with their own underlying portfolios of stocks or bonds. Although you own several funds, there is a chance that the holdings of those funds overlap – giving you a possibly unexpected overexposure to a single underlying stock (in Canada for example, many hold RBC). Checking concentration in this context will help avoid risk that can be diversified away.

Liquidity refers to your ability to sell your positions within a reasonable time frame. For example, if you have a short terms savings goal of a down payment on a house, you will need to be able to sell your investments (at a reasonable price) when that day comes. Having positions in less liquid investments like private equity or small cap/micro-cap stocks may pose a risk that you will not be able to get your money out in time.

Requirement: The advisor must consider the impact of costs.
Why Should I Care? The difference between a fund that charges 1% per year and 1.5% a year does not sound like much, but when you compound these fees over the time of your investment, they can be significant. The advisor should be considering these costs in your best interest.

Requirement: The advisor must consider a reasonable range of alternatives before making a recommendation.
Why Should I Care? There are roughly 24,000 mutual fund share classes and 1000 Canadian-domiciled ETFs available to Canadian investors. The fees that you pay your advisor are for their ability to recommend a suitable investment based on your circumstances. Looking at reasonable alternatives ensures that the advisor does not get tunnel vision when making a recommendation and may help them in finding a comparable fund that is offered with lower fees. Though the advisor does not need to pick the fund with the lowest fee (which in reality may not always be the right choice for you), they must demonstrate that multiple funds were considered.

Above all else, the advisor must ensure that the recommendation they make is in your best interest given all the information they know. In the case that the firm they represent does not offer an appropriate product, they must not make a recommendation.

Questions to Ask Your Advisor:  
-Can you show me a list of funds that you considered and tell me why you picked this one for me?
-Can you tell me how much of my portfolio is in TKTK (enter security of choice) stock (including mutual funds and ETFs)? 

This is a multi-part article series designed to inform investors on in-progress and upcoming changes to the regulations set out by the Canadian Securities Administrators having to do with Client Focused Reforms. Part 1 – Know your Client, Part 2 – Know your Product, Part 3 – Suitability and Part 4 – Conflicts of Interest

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About Author

Ian Tam, CFA  is Investment Specialist at Morningstar Canada. 


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