With the possibility of a ban on mutual fund trailing commissions in the air, industry compensation structures are facing increased regulatory scrutiny. The recent move by regulators to kill one such structure shows that the pressure to be up front with clients is intensifying.
In late July, an Ontario Securities Commission (OSC) bulletin called out mutual fund companies for potentially misleading investors through the use of a new fee structure that replaces embedded trailer fees with direct payments by clients to dealers.
On its face, this is the type of innovation that regulators should welcome. Moving from largely hidden trailer fees to clients paying directly for the services they receive should soothe regulators’ worries about the conflicts of interest and disclosure deficiencies inherent in the current model.
However, the OSC is worried that these arrangements may amount to little more than repackaging the same old hidden fees without necessarily improving clients’ understanding of what they’re paying and why.
“In our reviews,” says Rhonda Goldberg, director of the OSC’s Investment Funds and Structured Products Branch, “we are focused not only on technical compliance but with ensuring that the spirit and intent of our requirements are met.”
What the OSC found is that some fund companies – AGF Management Ltd., Mackenzie Financial Corp. and CI Financial Corp., for example – now offer series of their funds that do away with traditional trailer fees in favour of a “dealer service fee” that is paid by the investor directly to the dealer. However, rather than having investors write cheques to their dealer to cover this cost, units of the investors’ fund holdings are redeemed (generally, on a quarterly basis) and the proceeds are paid to the dealers.
It’s not the idea of replacing trailer fees with dealer service fees – or the fact that these payments are made via fund redemptions – that raised the OSC’s hackles. Rather, the regulator objects to the fact that fund companies are establishing “default” rates for these fees. Unless a dealer receives written instructions to the contrary, the dealer service fee will be paid at a predetermined rate.
For example, a fund may be structured to pay a dealer service fee of between 0% and 1.5% of assets under management per year. In theory, that rate is to be negotiated, and agreed upon, between the financial advisor and the client. However, fund companies are setting a default rate for these fees, often at the high end of the range – so the fee may automatically be 1%, or even the maximum 1.5%, unless the dealer is told otherwise.
The OSC’s concern is that the use of default fees may mean that these fees aren’t actually negotiated with clients. If clients don’t have to agree explicitly to be charged an ongoing fee, then advisors don’t have the incentive to discuss fees with them. In that case, these arrangements may amount to little more than hidden trailer fees in the guise of transparent, negotiated deals that leave clients no better informed or engaged in ensuring they’re receiving value from their advisor.
“Ultimately,” says Goldberg, “we want to ensure that investors understand the various options available to them for compensating their advisors, so that [investors] have real choices.”
Allowing fund companies to impose a default option, which may take advantage of known behavioural biases or keep investors in the dark altogether, would appear to be the enemy of client understanding and choice.
According to the OSC bulletin: “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.”
The bulletin adds that this fee may be misleading to investors, that fund companies may not be disclosing these arrangements properly and that dealers will have to disclose such fee arrangements under the new reporting requirements that are being phased in as part of the client relationship model reforms.
“As we continue to focus on mutual fund fee structures and dealer compensation models,” Goldberg notes, “we’re asking for greater clarity from fund managers to ensure that investors have a clear understanding of the costs of the fund and, specifically, how their advisor is being compensated.”
New funds won’t be allowed to have this feature, according to the OSC, and funds with default fees will be expected to provide notice of how long they will need to phase out such fees when prospectuses are renewed.
It’s not clear just how many funds, or fund companies, will be affected by this decision. The OSC examined disclosure from several fund families in order to determine how common these default fees are, and found that while some funds and fund managers are using them, not all are.
Investment Executive also sampled a number of prospectuses and Fund Facts documents from several of the larger, independent fund companies and found these kinds of fees in use at several of the biggest firms.
However, in some cases, these offerings are so new that the disclosure indicates that there aren’t any investors in these fund series yet. And a number of these funds are offered only as part of investment programs with $100,000 minimums – suggesting that such fee structures probably aren’t widely used just yet.
Jon Cockerline, director of policy and research with the Investment Funds Institute of Canada, says that the OSC’s bulletin was the first he’d heard of these structures. Because the OSC has signalled its intention to focus on compensation models, he adds, “now, in its sweeps, [the OSC] looks at this area a lot more closely than ever – so [regulators] are uncovering things that may have existed before, but now they’re more tuned in to them.”
Cockerline says that the regulators have sent “a clear message” that they don’t want to see this type of default structure used. And, he adds, they are well within their mandate to do that: “[The OSC] is the regulator, and that’s a fair thing to do. I don’t think there’s any objection to that from anybody, except maybe the particular fund company that’s asked to stop doing what it’s doing.”
In an environment of intensified regulatory interest in mutual fund fee and compensation structures, default fee arrangements are coming under greater scrutiny. The Canadian Securities Administrators is considering whether to take any sort of action on traditional industry fee structures, including limiting or banning trailers.
And the investment fund industry is responding to the concerns that underlie these deliberations. Although default dealer fees now have been ruled out, Cockerline says, the availability of D-series funds “is one area that’s picked up.” He adds that there are about nine companies that now have lower-cost, D-series funds available in the discount channel.
“That’s a positive development that the industry has taken upon itself to do in response to a regulatory concern,” Cockerline says, adding that this represents “a good evolutionary move.”
Karen McGuinness, senior vice president, member regulation, compliance, with the Mutual Fund Dealers Association of Canada (MFDA), reports that the MFDA has been having more conversations with dealers looking to offer fee-based accounts to their clients over the past year or so.
This trend may well continue, as regulators explore key questions about the impact of industry compensation models. Earlier this year, the OSC tendered a contract for further research into two concepts: how different forms of compensation (such as sales and trailing commissions) influence mutual fund sales; and how the use of fee-based vs commission-based compensation affects retail investor results. The OSC has awarded the contract for one of those projects, which is underway, and is in the process of awarding the contract for the other one.
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