Despite taking the occasional shot at the investment industry, I have a few financial advisor friends remaining. One longtime friend is a very sharp investment advisor at the brokerage arm of a big bank. His firm’s compliance department won’t let us use his real name, so let’s call him Ulysses.
Ulysses and I often discuss industry hot-button issues over lunch. We most recently debated the 25-year-old deferred sales charge. Ulysses says the industry should kill the DSC; I’m not a huge DSC proponent but decided to take the pro side. Our discussion:
Ulysses: Back-end loads are something we should say goodbye to for a number of reasons. Just as it usually pays to do the most uncomfortable thing when investing, we must learn to do the same in our own practices. DSCs have long been a notoriously poorly explained approach to advisor compensation and, because of that, advisors recognize that DSCs are — in effect — concealed fees.
Dan: When I started in the industry, I was trained to explain that the client doesn’t pay me a cent but that the fund company pays me on his or her behalf. But the DSC mechanism is not inherently evil. The sneakiness disappears with simple disclosures that any compliance officer can embrace.
Ulysses: Yet, so few do explain this. Back-end-load funds have hurt our industry’s reputation. Many clients have told me they’ve dumped their advisors because of lack of communication or poor returns and then expressed shock at the prospect of the mutual fund company clawing back 4% of what they originally invested if transferred to our firm in cash. The trickle of discontent becomes a torrent.
Dan: This has nothing to do with the DSC; rather, it has to do with the failure to document advice properly. We both know that clients don’t retain what you tell them for very long. Advice — and details such as DSCs — must be documented in plain English. I agree with regulating disclosure about how DSCs work but not with regulating how investors pay their advisors.
Ulysses: When I started in this business in 1996, I used back-end loads for many clients. It was the way of things then. Fees and trailers were irrelevant, and a back-end load would give you the commission you needed to get paid.
I remember having conversations with other advisors about the nature of our business being one of giving advice and getting commissions at the same time. They replied: “That’s just the way the advice world works.” But I also remember debating that although we espouse patience and putting clients first, we got paid more for activity. What if the right thing to do was nothing? DSCs don’t reward advisors for that.
And, looking back, back-end loads were much more work — for example, explaining mechanics, allowable switches and inevitably rationalizing clawbacks.
Dan: I’m no DSC cheerleader. But everything you have said has to do with the advisor’s professional conduct, not with inherent DSC flaws. Sure, the DSC is easier for ethically challenged advisors to exploit. But there are conflicts with every form of advi-sor remuneration.
I started as an advisor in 1994. Although my training wasn’t ideal, I was encouraged to read prospectuses and then review the highlights with clients.
So, I sold DSC mutual funds but walked every client through the mechanics, rationale, fees and commissions.
When I woke them up, they seemingly understood it. And although many didn’t retain it all, they went home with documented advice and a marked-up prospectus. I didn’t make much money back then.
Ulysses: Dan, I recognize that removing the DSC model is difficult for our industry, and that it will be tougher for newer advi-sors to make ends meet without the 5% up-front DSC commissions. Perhaps new advisors’ compensation has to be altered to allow them to build a business.
The bank for which I work had put rookies on a special fee grid eight years ago because it was the right thing to do. The bank supported brokers who walked the walk.
Dan: It’s much tougher than it used to be. But that’s a case for a more professional mentorship model rather than for legislating behaviour.
Ulysses: More education, another course. But will that change behaviour?
Dan: No. But bringing young advisors along more gradually through better mentorship is a better model and can address the industry’s succession challenge. But you don’t create good advi-sors by tossing rookies into the deep end and holding their heads to see if they can swim.
Ulysses: OK, but you’ve said before that back-end loads encourage clients to stay invested. I don’t buy it. The DSC is not a barrier to investors dumping their investments in a panic when full switching among funds in fund families is allowed.
Dan: In theory, you’re right; any investor who had bought a DSC fund a few months ago need not wait six years to make big asset-mix shifts.
But my research has revealed two interesting long-term tendencies. The dollar-weighted average holding period for mutual funds reporting to the Investment Funds Institute of Canada has long been six to seven years, which is about the length of the standard DSC schedule. As for capitulation — selling early — mutual fund investors tend to trade less — not more — during down markets. But it will be interesting to see if reduced DSC use will shorten holding periods the way it had lengthened them through the 1990s.
Ulysses: Embedded compensation will be banned in Australia and Britain, according to my peers on LinkedIn. It’s time to remove them from Canada. Use the extreme test: either apply the DSC to all fund sales or charge trailer fees only. Which would clients choose?
Dan: Both are embedded commissions, but clients would choose trailer fees. Still, fee-based advisors also have big potential conflicts: they would prefer clients keep money invested rather than spend it on non-investment items. Even fee-for-service planners are incented to maximize the effective fees charged per hour of actual work on client files.
But one other positive of DSCs is that they help smaller investors afford financial advice — generous DSC commissions can pay advisors for giving investment advice to smaller accounts.
Ulysses: I’m familiar with that argument. But please note that my employer and its bank-owned competitors offer high-quality advice on a no-load basis. Clients with smaller portfolios are well served by Canada’s major banks on financial planning issues.
Dan: That’s one of the problems with eliminating DSCs: it effectively gives banks a monopoly on small clients, who, I’d argue, get better advice elsewhere. Plus, if your beef is with conflicted advice, you’re suggesting that the only choice most investors should have is to walk into the most captive sales channel in the country.
Don’t squeeze out independents. Legislate disclosure, let people choose how to pay advi-sors and let market forces decide. It’s already happening: DSC sales are half of what they were in the late 1990s.
Ulysses: The trend is, my friend, look at low-load funds … they’re like salt-reduced bacon. You know it’s a bad thing when you can get a “reduced” version. Low-load funds are just “DSC Light.” The implementation of “a little less of a bad thing” only highlights the need to remove the DSC structure once and for all. IE
Dan Hallett, CFA, CFP, is director, asset management, for Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for advisors, affluent families and institutions.