Client Focused Reforms Part 4: Conflict of Interest

What they are, and why they matter

Ian Tam, CFA 16 February, 2021 | 1:32AM

Financial Advisor with Client

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, the Know Your Product (KYP) requirement, and the Suitability requirement. Though we are looking at different parts of the regulation in isolation, know that they are designed to fit together. Today, we delve into Conflicts of Interest.

Canadians can rest easy knowing that our banking system is strong. However, our banking system is also highly integrated, meaning that a single institution can function simultaneously in multiple parts of the financial system. For example, a bank can operate as a market maker for securities, a lender for individuals or corporations, an asset manager, as well as offer wealth management and financial planning. This system offers a customer the convenience of end-to-end financial solutions, but on the other hand gives rise to inherent conflicts of interest. These can lead to unfortunate outcomes.

The Client Focused Reforms attempt to tackle this conflict within the context of the advisor and client relationship. As an investor, you should be aware of how these potential conflicts can impact your advisor’s ability to offer a reasonable recommendation. The CSA have given examples of conflicts of interest. Here’s how they could impact you as an investor:

Conflict: In-house/Proprietary Products
How This Affects You: If your advisor works at a bank branch, they often recommend a fund from the asset management arm of the same bank. For the bank, this is a slam dunk – they can use a massive distribution network built over decades and can take advantage of their economies of scale. But is it a slam dunk for you? How do you know that the fund you are being recommended is the best fund of that type? Perhaps there is a similar fund that has performed better with lower fees, but not offered at the bank. Hence, offering proprietary products is an inherent conflict of interest. This does not necessarily mean a wholesale change of the banking system, but that this particular conflict must be dealt with at the head office. One way that the CSA suggests to mitigate this conflict is for the bank to conduct regular analysis to ensure proprietary products being offered are indeed competitive against other funds.

Conflict: Internal Incentives to Sell Certain Products Over Others 
How This Affects You: If a firm chooses to compensate advisors differently for selling a particular product or series of products over another, the advisors might be tempted to sell the product that gets them the most money. This could affect their ability to provide an unbiased recommendation. Firms can address by ensuring policies are in place to disallow incentives like this.

Conflict: Embedded Trailers in Fee-Based Accounts
How This Affects You: If you have a fee-based account with an advisor (typically for larger account sizes), you pay an overall management fee directly to your advisor outside of the MER charged for each fund that you own. It is in your best interest that your advisor places you in fee-based share classes of funds (typically denoted with an “f” after the fund name), which have lower MER’s since the fee for advice is stripped out. If this describes you, and you find that there is a commission-based share class of a fund in your account for which you are being charged, this is a conflict. In essence, the advisor is charging you twice for advice – once within the MER of the commission-based share class, and again in the form of the overall management fee. A similar situation exists when you have a commission-based share classes of mutual funds being offered through discount brokerages (known formally as order-execution-only brokers), where no advice is provided. This was addressed by the CSA recently but firms have until June of 2022 to implement the changes.

Conflict: Compensation from 3rd Parties
How This Affects You: When your advisor makes a recommendation to you, they might be choosing from a list of products with which they are familiar. How are they made aware of these products? In some cases, the firm has a set list of funds that an advisor can recommend. In other cases, larger fund manufacturers (3rd parties) have a team of wholesalers who will actively promote and educate on their product offerings to advisors to attract additional assets to the fund. These 3rd party funds in some cases may provide different levels of compensation to the advisor through trailing commissions (part of the MER). The inherent conflict here is that an advisor may be compensated differently from different fund manufacturers. The regulation suggests that a firm can address this conflict by putting policies in place to ensure the merits of a fund are assessed before the effect of the compensation. Or in effect, putting funds on an even playing field and taking compensation out of the picture.

What the Client Focused Reforms Say:
The requirements deadline for advisors and their firms to disclose conflicts of interests is June 30, 2021 (with the remaining requirements of KYC, KYP, and Suitability on Dec 31, 2021). At this point, firms must be required to disclose to you in plain language (1) the nature of conflicts, (2) the potential impact and (3) how the conflict will be or has been addressed when making a recommendation to you. If the conflict cannot be addressed, it must be avoided which might mean not making a recommendation at all. 

Your Checklist:
-Look at your portfolio and count the number of proprietary funds (funds that have the same name as your bank) in your holdings. Does this seem disproportionally large?
-If you have a fee-based account with your advisor, check that there are no embedded commissions being charged for the funds that you own within that account.

Questions to Ask Your Advisor:  
-Do you only deal in proprietary/in-house funds?
-Can you show me that the recommendation you’re making is competitive against funds that aren’t offered through your bank?
-How you are being compensated for the sale of this fund?

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About Author

Ian Tam, CFA  is Director of Investment Research at Morningstar Canada. 

 

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