A new paper from the Canadian Securities Administrators (CSA) throws out a number of possible options to address the conflicts posed by embedded trailer commissions, including everything from banning trailers to unbundling them, capping commissions, or requiring advisors to provide a minimum level of service.
The CSA published a discussion paper Thursday that examines the mutual fund fee structure in Canada, and potential investor protection issues arising from that structure, including: a lack of investor understanding of embedded commissions, their lack of control over those costs, and the perverse incentives and inherent conflicts of interest they pose.
The paper notes that these commissions are on the rise, and have come to account for almost two thirds of advisors' revenues. It reports that, in 2011, mutual fund manufacturers paid an estimated $4.6 billion in trailing commissions, representing 34% of total revenue from management expense ratios (MERs) for the year. Furthermore, it says that since 2006, trailing commissions for stand-alone mutual funds have risen slightly. "The trend appears to be towards higher average trailing commissions for both bank and non-bank mutual funds and across asset classes," it says.
And, it notes that advisors are increasingly relying on trailing commissions as a source of revenue. Back in 1996, trailing commissions accounted for slightly more than one quarter of the advisor's book of business. In 2011, their share is 64%, it says.
While the rise in trailing commissions clearly benefits fund firms and advisors, the paper notes, "The potential or perceived benefit to investors of an increase in the trailing commission is less clear. While investors might reasonably expect a commensurate increase in services and advice from their advisor, or some other observable benefit, there is currently no evidence to substantiate that this is what occurs. This lack of a clear benefit to investors gives rise to the conflict of interest issues..."
Traditionally, Canadian regulators have relied on disclosure to protect investors, but in light of the ongoing criticism of the cost of Canadian funds, conflict concerns, and the regulatory reforms that are being implemented in other countries to address similar issues, the CSA is also now contemplating whether more needs to be done here too.
Among the possible options set forth in the paper, the CSA suggests that: trailers could be banned outright; or, there could also be a maximum limit set on the portion of mutual fund assets that could be used to pay trailing commissions. It also suggests: a minimum level of ongoing services that advisors must provide to investors in exchange for trailer commissions could be established; mutual funds could be required to provide a class of funds for do-it-yourself investors that pay no trailers; trailers could be unbundled and charged/disclosed as a separate asset-based fee; and, a separate series of funds could be required for each purchase option. Additionally, it suggests that regulators could impose a "best interests" duty on advisors, as is being examined in a separate discussion paper, in order to mitigate conflicts.
The paper notes that while banning trailers outright "would have the greatest impact on current business models, it would also be the most straightforward way to align the interests of both the mutual fund manufacturers and the advisors with those of investors."
Coming in the form of a discussion paper, the possible options presented by the CSA are clearly a long way from being adopted, if at all. Indeed, the CSA notes that it intends to monitor the impact of ongoing disclosure initiatives, such as the introduction of Fund facts disclosure documents and new cost and performance reporting requirements, "to determine whether these initiatives appreciably improve investors' awareness and understanding of mutual fund costs, make them more informed consumers of investment fund products and advice services, and promote effective competition among financial industry participants."
The CSA also intends to monitor the various global reforms, such as the move in the UK to ban embedded commissions, and Australia's ban on commissions. In the meantime, the CSA intends or this paper (which is out for comment until April 12, 2013) to serve as launching pad for a discussion of these issues in Canada too, "to determine whether regulatory responses are needed in Canada to enhance investor protection and foster confidence in our markets."
The CSA notes that the comments it receives on the paper will be considered in its decision and next steps, and will also assist in the development of a roundtable the CSA plans to hold with investors and industry participants in 2013.
"Mutual funds are a key investment in the portfolios of many Canadians," said Bill Rice, chair of the CSA and chair and CEO of the Alberta Securities Commission (ASC). "It is important that we look at Canada's mutual fund fee structure carefully in determining what changes could or should be considered to enhance investor protection and foster confidence in our market."