Mutual fund managers that are developing fee structures that replace embedded trailer commissions with direct payments from investors to dealers should not be adopting default fee features that simply replace one sort of automatic fee with another, regulators say.

In the latest edition of the Investment Funds Practitioner, a publication put out by the Ontario Securities Commission’s (OSC) Investment Funds and Structured Products Branch, the regulator reports on the latest evolution in mutual fund fee structures, which replaces the traditional trailer fees with new ongoing dealer service fees that ostensibly paid by the investor directly, rather than by their funds.

In these structures, the fund manager automates these payments by redeeming investors’ units and paying the proceeds to the dealer on a quarterly basis. According to the OSC, the fund managers often set a “default rate” for these fees, which can be the maximum of a stated range. For example, it says that if the disclosure sets out that these fees for ongoing service fall into a range of 0% to 1.5% per year, the default fee may well be 1.5%.

Regulators are concerned that this automatic approach can short circuit the negotiation of fees between investors and dealers. It says that while it doesn’t object to fund managers facilitating payments from investors to dealers, “staff are of the view that no such payment should be made pursuant to the application of a default rate.”

“In staff’s view, the default rate feature is inconsistent with a critical attribute of the direct payment series, namely the negotiation of the service fee, which is intended to provide investors with heightened transparency and a clear expectation of the services to be rendered in exchange for the negotiated fee,” it says. Effectively, the default rate feature may replace the negotiation of fees between investors and dealers, it suggests.

“Staff’s view is that the default rate feature blurs the lines between the attributes of the direct payment series and the embedded fee (trailing commission) series and is potentially misleading for investors,” it says.

The commission says that it has told fund managers that new funds should not have a default rate feature. And, that, as fund prospectuses are renewed, it will be asking fund managers that currently use them “to tell us what would be a reasonable transition period needed to remove the application of any default rate.”

“We continue to review and monitor developments on mutual fund fee structures and dealer compensation models and will provide further guidance as needed,” the commission concludes.