Oversight: a work in progress

Given their place at the heart of many investors’ portfolios, mutual funds have long been a regulatory focus. Yet industry oversight is perpetually a work-in-progress, thanks to long-standing, unresolved investor protection issues.

As the fund industry has grown, regulators have been steadily pushing the industry to increase transparency and curb conflicts of interest, while ramping up demands on financial advisors. Those demands are set to increase further, as regulators’ efforts have so far failed to quiet concerns about whether investors understand what they’re buying, and ensuring that they get a fair deal when they do.

Last year, the Canadian Securities Administrators (CSA) published two major sets of proposed reforms. One targets the mutual fund sector specifically; the other aims to enhance protection for retail investors generally. Concurrently, the Mutual Fund Dealers Association of Canada (MFDA) is pursuing its own efforts to enhance advisor proficiency and to further improve transparency to investors.

If the CSA’s reforms go ahead, those proposals could prompt seismic change. Last fall, the regulator proposed to effectively ban deferred sales charge (DSC) mutual fund structures and sought to prohibit mutual funds from paying trailer fees to discount brokerage firms for investment advice.

These proposals followed an earlier set of CSA reforms – known as its client-focused reforms, published in June 2018 – that would revise existing suitability, “know your client” and conflict of interest rules, in an effort to raise investor protection standards generally (not just for mutual funds).

Taken together, these rule changes could fundamentally reshape the industry by pushing it to modify traditional compensation structures, intensifying the shift to low-cost, index-based products from costlier actively managed funds, and altering the competitive balance between in-house and third-party products.

Ordinarily, such transformative changes would take years to finalize, as regulators typically engage in prolonged industry consultation. At this point, however, the outlook for reform is even more uncertain, as regulators are also in the midst of a wide-ranging effort to streamline regulation – prompted by the new government in Ontario, which oversees the country’s largest, most influential regulator, the Ontario Securities Commission (OSC).

Not only does Ontario’s new government explicitly oppose the CSA’s move to ban DSCs, but it is also pushing the OSC to examine the cost of complying with regulation, and to seek ways to reduce those costs as part of a broader initiative to reduce regulation throughout the province. In the face of this push for deregulation, the CSA hasn’t abandoned reform, but it will face more forceful headwinds.

The OSC indicates that regulators are aiming to revise both sets of proposals (fund fees and client- focused reforms) and publish them for further consultation in the fiscal year ending March 31, 2020.

Whether that will happen at a time when resources are being diverted toward reducing regulatory burdens is unclear, but it appears unlikely that these proposals will be implemented soon. Revised proposals would go out for further comment, and will likely take months, if not years, to finalize.

Meanwhile, the fund industry is facing initiatives from the MFDA that would also alter the regulatory landscape, albeit less dramatically.

Over the past couple of years, the self-regulatory organization has been consulting with the industry on the idea of introducing continuing education (CE) requirements for dealer reps as a way of increasing their proficiency standards.

At this point, the MFDA is waiting for the CSA to sign off on its proposed CE rule, and indicates that it’s developing a system for tracking registrants’ compliance. Once these requirements are adopted, registrants will be expected to collect CE credits on an ongoing basis.

The MFDA is also exploring the prospect of further enhancing transparency by expanding on the cost-reporting requirements that were adopted as part of the second phase of the client relationship model (CRM2). CRM2 requires firms to provide investors with annual reports setting out dealer-imposed costs in dollar terms, and the MFDA is leading an initiative to explore expanding this reporting to cover costs charged by funds themselves, such as management fees and fund-operating costs.

The objective is to provide clients with even more comprehensive cost reporting and greater insight into the overall costs of investing. It may also level the playing field between vertically integrated firms that have fund manufacturing and distribution under the same roof, and the industry’s independent dealers.

While this initiative has industry support, it seems further from fruition than are the CE reforms. If the process for finalizing specific details of the CRM2 requirements is any guide, it will likely be a couple of years before regulators settle on detailed reporting requirements. Then, the industry will have to start implementing changes.

So, while the timing of reform and the pace of change remain up in the air, the direction of travel is not in question – regulators’ demands on the fund sector are only going up.