Are the reforms in phase 2 of the client relationship model (CRM2) primarily intended to alert investors to the total costs of investing? Or are they really to sensitize them to the cost of advice?

That’s the issue underlying an ongoing debate among regulators about how vertically integrated mutual fund dealers should report costs to clients.

Although the details of the CRM2 reforms have been exhaustively debated over the past several years, another issue recently emerged. The question concerns integrated dealers – firms that have both fund manufacturing and fund distribution under one roof – and the reporting that these firms should do when the new annual cost reporting requirements come into effect in July 2016.

In theory, firms that house both businesses could decide to allocate little to none of investors’ total costs to distribution, allowing those dealer firms to report very low distribution costs to clients on their new CRM2 reports. This strategy also may minimize the prospect of awkward conversations with clients who otherwise might suffer sticker shock when they see a report that spells out in dollars and cents precisely what they have paid in trailer fees over the previous year.

The concern for regulators is that this approach would undermine the spirit of CRM2, which is intended to enhance transparency to clients and improve investor protection by giving clients a clear picture of what they are paying for ongoing service and advice from their dealers. This end-around strategy also could give clients a distorted picture of the cost of dealing with an integrated dealer vs an independent dealer.

Karen McGuinness, senior vice president, member regulation, compliance, with the Mutual Fund Dealers Association of Canada (MFDA), reports that the MFDA has seen a variety of approaches to allocating investor costs (revenue, from the dealers’ perspective) by integrated firms. These range from costs that allocate nothing to distribution to firms that report allocations that are more or less consistent with what third-party dealers report. Other integrated dealer firms appear to fall somewhere in between those positions, booking distribution revenue at rates that are not zero, but that also are not consistent with what’s typical at independent dealers.

There also is no clear answer to the question of how regulators should approach this issue. Allowing firms to report no distribution cost to clients (even if they choose to structure their business this way) seems unfair and inaccurate. The regulators could require firms to impute (and report to clients) a “fair value” to distribution. Or, the regulators simply could require firms to report the total cost of both management and distribution to clients.

The fair value approach would give clients a reasonably accurate picture of the cost of distribution. However, defining what is a “fair” cost of distribution may be easier said than done, and could allow for excessive variation between firms, hampering investors’ ability to compare costs among firms.

The “total cost” approach appears to be the more straightforward way to go. It would do away with any sort of guesswork. It also avoids the problem of having firms declare a hypothetical cost, particularly as clients will be receiving disclosure in dollars rather than in only percentage terms. (Disclosure in dollars implies a higher level of precision and is intended to be a more meaningful number for clients.)

On the other hand, the total cost method may not give clients much insight into the cost of advice. Although clients are likely to understand the full costs of investing better through this method, that wouldn’t necessarily help clients figure out whether they are getting value from their dealer, or put clients in a better position to negotiate a more favourable deal from a firm.

Steadyhand Investment Funds Inc. of Vancouver is one firm that is already using the total cost approach in its reporting to clients. “We’ve always reported total costs because that’s what it costs,” says Tom Bradley, Steadyhand’s founder and president. “It wasn’t a reaction to regulatory pressure, but rather a response to the question: ‘What do our clients want and need to know?'”

McGuinness says the MFDA is still debating the issue internally and discussing it with both other regulators and industry firms. Yet, at this point, no decision has been made on what, if anything, the regulators may require.

McGuinness makes clear that firms will not be permitted to claim that distribution is cost-free in their CRM2 reports on charges and compensation; firms will have to disclose some cost. She adds that most of the dealers that the MFDA has talked to are planning to use either the total cost approach or the fair value approach. But this issue may well be one that ultimately requires some form of regulatory guidance.

The Canadian Securities Administrators (CSA), which has the final word on CRM2, acknowledges that it is aware of the debate about how to deal with integrated dealer costs. The CSA is discussing solutions with the MFDA.

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