Reducing the regulatory burden and fostering innovation in the financial services industry are trendy goals for policy-makers at the moment. However, a new reform proposal that seeks to do both for fund dealers highlights the clash of priorities that arises when these demands run headlong into reality.
The Mutual Fund Dealers Association of Canada (MFDA) is proposing a reform that would allow fund dealers to engage in a limited form of discretionary trading which would enable dealers to tweak model portfolios for their clients more easily.
As the situation stands, fund dealers that offer clients model portfolios either have to engage an external portfolio manager to run the products or operate them in-house by getting clients to sign off on portfolio changes — i.e., changes that are beyond routine rebalancing — such as adjusting asset allocation in response to changing market conditions or replacing an underperforming fund.
The MFDA proposes to allow fund dealers to make such portfolio changes unilaterally. According to its proposal, the anticipated impact of the reforms “will be to improve client service and reduce regulatory burden, while maintaining or enhancing investor protection.”
The initiative comes at the behest of dealer firms seeking the freedom to innovate while reducing regulatory burden. These arguments gained traction with MFDA staff, who concluded that the sector’s call for regulators to allow dealers to engage in limited discretionary trading can be accommodated without impairing investor protection.
The MFDA, a self-regulatory organization (SRO), suggests that enabling dealers to manage their model portfolio programs more fully could bolster investor protection by doing away with the need for an external portfolio manager to eliminate potential confusion over accountability. If only the dealer is involved, a single firm (i.e., the dealer firm)would be responsible for any problems.
Despite the contention that client service, dealer efficiency and investor protection will benefit, the consultation that has followed the proposals indicates that the competing goals of innovation, investor protection and burden reduction don’t necessarily sit together easily.
Investor advocacy groups, such as the Canadian Foundation for Advancement of Investor Rights (FAIR Canada) and the Ontario Securities Commission’s Investor Advisory Panel (IAP), are concerned about the ramifications of introducing discretionary trading capabilities to an investment industry segment in which such trading has historically been prohibited.
There is an array of concerns within the mutual fund sector. While firms overwhelmingly support the objective of the MFDA’s proposal, they have questions about the details. Some comments indicate that the mechanics of how the rules will work need to be fleshed out.
For example, the MFDA proposal envisions that both the dealer and its reps who engage in discretionary trading would have to be either registered to provide discretionary portfolio management services or be exempted from registration.
This approach would be tougher than the one in the investment dealer world, in which firms don’t have to register to provide discretionary portfolio management; only reps providing the services face that added obligation. The MFDA’s proposal of a more restrictive approach represents a concern for some in the sector.
The Investment Funds Institute of Canada’s (IFIC) comment on the MFDA’s proposals states that requiring dealers to register as portfolio managers is redundant. Instead, IFIC’s comment suggests the better approach is to exempt fund dealers from the added registration requirement — subject to conditions that need to be spelled out in the MFDA’s proposal.
“Providing relief will ensure that efforts to reduce regulatory burden are not offset by increasing regulatory complexity and costs through dual registration, oversight and duplicative requirements,” IFIC’s comment states.
In addition, IFIC’s comment states, the SRO needs to define what a model portfolio program is for regulatory purposes. The comment also recommends that these arrangements be governed by agreements between dealers and clients, which would enable firms to be exempt from certain pre-trade disclosure requirements. (Again, this requirement would mimic the rule in the investment dealers’ world).
The investment fund sector’s call for a more detailed proposal is echoed by investor advocates, the comments from which express concerns about the need to define what constitutes a model portfolio. The concern is that without a detailed definition, firms may be tempted to engage in more expansive discretionary trading than what’s envisaged in the regulator’s proposal.
The Canadian Advocacy Council for Canadian CFA Institute Societies’ (CAC) submission states the proposed rule should limit dealers’ discretion.
For example, the CAC’s comment states that a dealer shouldn’t be able to replace a broad-based large-cap equity fund with a small-cap or sector fund – even though both are equity funds. The comment states: “While the client account might have the same asset mix [in this scenario], the portfolio risk could be quite different.”
The CAC’s comment also suggests that the regulators should put limits on the asset-allocation changes that dealers can make: “For example, tolerance [surrounding] strategic asset weightings in the range of +/-2% might be appropriate, while more substantial changes could be more problematic.”
Another key policy consideration is potential use of technology in these portfolio changes. The freedom for dealers to adjust portfolios more quickly could enable increased use of artificial intelligence, predictive analytics and other decision-making technology to drive these changes. The prospect of this sort of innovation, and its implications, are not specifically addressed in the proposal.
Alongside calls for more detailed requirements, some comments state that the introduction of discretionary trading authority should be accompanied by overarching principles. Both FAIR Canada’s and the IAP’s comments argue that the reps engaging in discretionary trading should be explicitly subject to a fiduciary duty, thus obliging the reps to put clients’ interests first.
The IAP comment states: “Short of this requirement, the IAP would have concerns that the [MFDA’s proposal] could result in situations [in which] discretionary trading may not always be conducted in the best interests of the portfolio’s investors.”
This belief in the need for a fiduciary standard for reps providing discretionary trading is echoed in the comment from the Portfolio Management Association of Canada (PMAC), an investment industry trade group, which states that it “strongly believes that all registrants entrusted with managing client assets on a discretionary basis should owe those clients a fiduciary duty of care.”
If that’s to be the case, PMAC’s comment states, the regulators need to consider how such a fiduciary duty would operate in practice. In particular, PMAC’s comment questions what will happen if certain services a client receives are subject to a fiduciary duty (i.e., discretionary trading), but other services are not.
PMAC’s comment states: “It is not clear how a regulator, an investor or a court would be able to parse out the portions of a portfolio [with] respect [to] which an investor should expect that his or her best interests were put ahead of those of the MFDA member. We question what outcome that would provide investors.”
In addition, the PMAC’s comment questions whether the proposals could lead to increasing regulatory arbitrage — fewer firms could decide to register as portfolio managers because they can provide comparable services as an SRO-regulated dealer.
PMAC’s statement warns: “We strongly caution against creating back-door channels for providing discretionary investment management to investors without comparable duties of care, proficiency, compliance and regulatory oversight requirements. To do so may provide incentives for firms and individuals to assess the regulatory landscape for the easiest route to performing discretionary asset management.”
The consultation highlights the fact that a regulatory policy that seeks to enable innovation or reduce compliance costs in one corner of the investment fund sector can be a competitive threat to another segment of the business — not to mention a challenge to ensuring investor protection.
PMAC’s comment adds: “Cost savings and efficiency cannot and should not come at the price of investor protection or at the risk of creating nebulous duties toward investors.”
Another competitive concern flagged in a couple of the comments relates to the potential for conflict of interest that may arise between in-house and third-party products in a scenario in which fund dealers with affiliated fund manufacturers have discretionary trading authority.
For example, the comment from the Financial Advisors Association of Canada (a.k.a. Advocis) states: “Where independent, third-party products are substituted with a proprietary product, firms may have internal incentives and compensation practices that give rise to potential conflicts of interest.
“Although portfolio managers are expected to act in a client’s best interest,” the comment continues, “this standard may be more difficult to apply and to audit when dealing with proprietary products.”
The need for oversight of this trading activity — by both dealers and the regulators — also is a concern.
The association’s comment recommends that these risks be dealt with through enhanced disclosure requirements and oversight of discretionary trading involving in-house products.
The CAC’s comment states: “If the [proposal] moves forward, it will be important for the MFDA to engage in regular targeted reviews of any discretionary trading.”
PMAC’s comment, on the other hand, states that some oversight by the provincial regulators (which directly supervise portfolio managers) will be necessary too, adding that the proposed rule should specify the details of such oversight.