Canadian Securities regulators once again are contemplating fundamental reforms to protect investors from the inherent conflicts posed by the mutual fund sector’s fee structures.

Late last year, the Canadian Securities Administrators (CSA) published a discussion paper that analyzes the mutual fund sector’s fee structures, as well as the investor-protection concerns that arise as a result. This paper lays out a menu of dramatic reform options to alleviate those concerns, from banning trailer fees to requiring fund firms to unbundle them or demand minimum levels of service from financial advisors who collect these fees.

At the heart of the CSA’s concerns is the fact that many investors still aren’t aware of – or don’t understand – embedded trailer commissions.

And even if investors are aware of these trailers, a further concern is the fact that these fees are taken out of fund assets and paid by fund manufacturers to dealers and advisors – which cuts investors out of the equation and eliminates their bargaining power and their ability to control their investing costs while also reducing competition among advisors and devaluing advice.

The existence of trailer fees also leads to absurd results, such as discount brokerages’ clients paying trailers, ostensibly for advice that they never receive.

The issues the CSA paper illuminates are not new; they have been well understood by regulators for the better part of the past 20 years – since 1995, at least, when Glorianne Stromberg, then commissioner of the Ontario Securities Commission (OSC), produced her first landmark report on the mutual fund sector.

The OSC’s attempt to create its fair-dealing model, which began in 2000, addressed many of the same issues. Now, regulators are back for yet another kick at the can.

The response to the CSA paper by the Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada) indicates the investor advocacy group believes the CSA’s latest effort represents a thorough discussion of the issues posed by sector fee structures. Marian Passmore, FAIR Canada’s associate director, says that embedded, third-party commissions, such as trailers, “carry serious potential for conflicts of interest and present high, opaque costs to financial consumers.”


FAIR Canada also worries that the existing system creates perverse incentives for fund firms to create increasingly expensive products in order to win advisors’ business rather than more cost-effective products designed to woo the investor.

Indeed, the CSA paper indicates that trailer commissions are on the rise. It reports that since 2006, trailing commissions for stand-alone mutual funds have risen slightly and, it notes: “The trend appears to be toward higher average trailing commissions for both bank and non-bank mutual funds and across asset classes.”

Moreover, these commissions have become ever more important to advisors’ books. In 1996, around the time of the original Stromberg report, trailers accounted for about 25% of the average advisor’s annual revenue; now, according to the CSA report, trailers’ share of advisor revenue is up to almost two-thirds (64%).

The increased significance of trailers makes the dilemma even tougher for regulators. The fact that investors collectively paid about $4.6 billion in trailer commissions in 2011 – fees that regulators acknowledge many investors aren’t aware of and which inherently are conflicts of interest – would seem to represent an ever more powerful argument for action.

@page_break@Yet, at the same time, the increased importance of trailers for the financial services industry means any significant reform will be that much more disruptive and, therefore, doggedly resisted.

Certainly, the CSA paper does not shy away from recognizing the sorts of fundamental changes that would be required to deal with these issues decisively, once and for all.

For example, the CSA paper suggests that resolving the inherent conflicts posed by embedded trailer commissions could be done by banning trailers outright, as has been done in Britain and Australia recently.


Alternatively, regulators could force firms to unbundle those commissions, cap them or require advisors to provide a minimum level of service in exchange for their trailers.

The CSA paper also suggests that fund firms could be required to create classes of funds for do-it-yourself investors that would pay no trailers, among other things.

Still, the CSA isn’t proposing to adopt any of these measures just yet. It’s throwing the alternatives open for discussion, but isn’t committing to any particular course of action. Nor does the CSA paper say that any of these reforms are definitely needed.

Moreover, the CSA paper indicates that the regulators intend to monitor both the effects of existing domestic efforts to bolster disclosure and the reforms being adopted in Britain, Australia and elsewhere to see how those work before considering further reforms.

To Passmore, this ambivalence signals that the regulators aren’t going to be acting on this paper anytime soon. The CSA paper suggests, she says, “that the CSA likely will not put forth a recommendation banning third-party embedded commissions, including trailing commissions, for a considerable period of time.”

Stromberg isn’t sure whether the CSA finally is ready to do something to address these long-standing issues, either. And, in any case, she suggests, the regulators’ effort ” falls short of focusing on the fundamental issues.”

Among the issues the CSA paper fails to address, she says, are: the lack of competition in the mutual fund sector, which allows fund costs to remain high; the appropriate cost/value of advice; and the ultimate impact of these persistently high costs on the ability of Canadians to provide for themselves.

“Permitting these capital-eroding fees,” Stromberg says, “will impact the need for social support systems that we simply do not have – and probably won’t be able to afford, given the erosion of the tax base as the population ages.”

© 2013 Investment Executive. All rights reserved.