Special Feature

The end of embedded commissions? How we got here

The Canadian Securities Administrators (CSA) published a consultation paper on Tuesday in which it proposes to consult with stakeholders for an extended comment period of 150 days on the option of discontinuing embedded commissions and making a transition to direct pay arrangements.

 

The move to consider a ban on embedded fees follows research the CSA commissioned from York University professor Douglas Cumming in 2015, which showed that these compensation structures distort sales and impact investment performance.

 

Included in this special feature are the notable developments in this area over the past few years highlighting how we got to the release of the CSA's consultation paper. Photo copyright: cherezoff/123RF.

New research confirms regulator's concerns about fund fees and potential conflicts of interest

By James Langton | Mid-November 2015

NEW RESEARCH ON MUTUAL fund fees from the Canadian Securities Administrators (CSA) is both intuitively obvious and oddly startling. What will the regulators do with it?

After repeated delays, the CSA finally released in late October the results of research the regulator commissioned last year into whether mutual fund fee structures have an impact on fund sales and investors' portfolio performance.

Common sense would suggest that fees do affect both sales and returns. And this intuition is largely confirmed by the empirical data set out in this report.

The research found that the presence of trailer fees increases fund flows, regardless of past investment performance. And the higher the trailer fee, the less sensitive a fund's sales are to its past performance. Moreover, the study found, funds that are less sensitive to past performance tend to perform worse in the future. The report also concluded that higher trailer fees affect future returns negatively.

At one level, much of these conclusions seems obvious. Of course, trailer fees are relevant to mutual fund returns. As part of the expenses of a fund, trailer fees naturally have a direct impact on a fund's results. And, given that the purpose of these fees is to finance distribution, it is not surprising that they help to drive fund sales.

Although these conclusions may seem self-evident, having these ideas confirmed by hard data drawn directly from the Canadian fund industry is significant nevertheless. Now, regulators don't have to speculate or extrapolate research from other countries in order to understand the importance of fund fee structures. The CSA now has empirical evidence from domestic data.

Those data are extensive. The CSA commissioned this research from Douglas Cumming, finance professor at the Schulich School of Business at York University in Toronto. Cumming, along with a couple of Schulich colleagues, Sofia Johan and Yelin Zhang, conducted the research with the benefit of a unique set of data provided by the fund industry. The sample included 10 years of data on 43 fund families, representing $746 billion of assets under management and more than 22,000 FundSERV Inc. codes. This data comprises more than one million fee, flow and performance data points per month.

Although obtaining these data from the industry initially was not easy for the researchers, the volume of information they ultimately managed to get their hands on is large enough to ensure that the research has statistical significance. The level of detail these data provide also crystallizes the impact of fees on fund flows and performance.

For example, the research found that a 1% increase in trailer fees is associated with a drop in future returns of about 1.43%. In effect, a trailer-fee hike represents a transfer of wealth from unitholders to dealers and, by implication, financial advisors.

Similarly, the research found that when a fund reduces its trailer fee, the fund's returns increase after the change. The research determined that funds that sell through affiliated dealers tend to perform worse than funds that have independent distribution. The study also discovered that investors are sensitive to fees when they invest in a fund directly. In these situations, the research report states: "When a fund charges more, investors are less likely to invest and [they] invest less."

The research appears to validate some of the regulators' concerns that were spelled out in the CSA discussion paper that launched this inquiry in the first place in late 2012. For example, the fact that trailers do affect fund sales and performance would appear to support the suspicion that the current fee structure creates potential conflicts of interest for both advisors and fund manufacturers.

The research also appears to support the fear that there may be a mismatch between what investors pay in trailer fees and what they receive in the form of service and advice. "In practice," the paper notes, "trailer fees pay for many things not associated with advice. There is currently no legal requirement to provide advice in order to receive a trailer fee."

For investor advocates, this latest research simply adds to the weight of evidence that the current industry structure needs reform. "Cumming's findings validate much of what previously had been thought about trailers, and the findings accord with common sense. They cannot be ignored," says Neil Gross, executive director of the Toronto-based investor advocacy group, the Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada). "It's time for the research to be translated into reforms - either by the adoption of a 'best interests' standard or at least by banning trailing commissions."

A CSA paper issued almost three years ago set out several policy options that the regulators could consider in order to address their concerns. These include banning trailers and imposing a "best interest" duty on advisors. Less intrusive options include capping commissions and establishing minimum service levels in exchange for trailers.

The new research report doesn't draw any conclusions about how the regulators should respond to its findings. And the CSA, for its part, now says that it expects to make a policy decision on these issues in the first half of 2016.

Joanne De Laurentiis, president and CEO of the Investment Funds Institute of Canada (IFIC), says IFIC is reviewing Cumming's paper internally and with members. For now, IFIC offers no comment on the research itself.

Similarly, the Investment Industry Association of Canada isn't commenting on the research results, stressing instead that forthcoming regulatory reforms - such as the remaining client relationship model reforms and the point-of-sale delivery requirements for mutual fund disclosure - should be fully evaluated before further changes are decided upon.

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