Commissions-based compensation creates enough of a policy problem to justify regulatory action, concludes new research from the Canadian Securities Administrators (CSA). But while the research suggests fee-based compensation is likely a better model, it cautions that banning commissions wouldn't necessarily improve clients' financial results.
The CSA published the literature review component of its mutual fund fee research on Thursday, which was carried out by the Brondesbury Group. The other aspect of its research into the influence of sales and trailer commissions on sales in the Canadian mutual fund industry is expected to be released later this summer. Douglas Cumming, professor of finance and entrepreneurship and Ontario research chair in economics and cross-cultural studies at York University's Schulich School of Business in Toronto, is carrying out that part of the research.
In the meantime, Thursday's report from the CSA concludes that the academic literature shows that commissions-based compensation models do create a variety of problems and that "the evidence on compensation is conclusive enough to serve as a basis for policy formulation."
For example, the CSA report finds that research on the mutual fund industry shows that mutual funds that pay commissions underperform on a raw, risk-adjusted and after-fee basis; that higher embedded commissions drive mutual fund sales; and that financial advisor recommendations are sometimes biased in favour of products that generate more commissions for them.
The CSA research also shows that mutual fund distribution costs raise expenses and lower investment returns; that advisors push investors into riskier funds; and that investors cannot easily assess what form of compensation is best for them.
Moreover, the CSA report also finds that in markets in which regulation has been changed to ban, or limit, commissions, there is evidence that this has impacted investor outcomes. For example, it reports that without embedded compensation, advisors recommend lower-cost products, which typically have better returns because of their lower expenses.
However, the research also reveals that although fee-based compensation "is likely a better alternative," it cautions that "there is not enough evidence to state with certainty that it will lead to better long-term outcomes for investors."
Indeed, the CSA report suggests that shifting to fee-based models won't cure all the ills facing the mutual fund industry. For example, it says that mis-selling based on investors being pushed into riskier products "will not be eradicated by a change of compensation regime, but it will likely be diminished."
It's unlikely that the behavioural biases of investors will be overcome solely as a result of changing compensation schemes, the report adds, "although it is possible they can be moderated."
In addition, advisory fees may rise in the absence of commissions, and other types of fees — such as administrative fees — may be introduced, or increased, to compensate for the removal of commissions, the CSA report finds. It adds that investors may also face higher costs on margin accounts and receive lower rates on their cash balances if firms don't have commissions driving their revenue.
The CSA report also notes that less affluent investors "find it harder to get advisory service" in markets that have fee-based compensation vs those that use commissions. However, it stresses that it's not clear whether this difference is due to a ban on commissions or not.
"We do not know whether it is more difficult [for smaller clients to get advice] with fee-based compensation than it was before the change in compensation regime," the CSA report says, pointing out that alternatives, such as robo-advisors, are being developed to fill the advisory gap.
Lastly, the CSA report poses a series of questions for future research that would improve policy formulation on compensation; help understand the impact of alternative compensation schemes; and help policy-makers minimize undesirable and unintended consequences.
"The Brondesbury Report, together with the comments received during our stakeholder consultations and the forthcoming research by professor Cumming, is intended to be among the inputs that will be factored into the CSA's determination of whether to effect certain policy changes," said Louis Morisset, CSA chairman and president and CEO of the Autorité des marchés financiers.
It's expected that the CSA will reach a decision about whether to intervene on industry compensation schemes within its current fiscal year, which ends on March 31, 2016.