The Globe and Mail, Report on Business
Published January 19, 2013

By Tom Bradley

A young client phoned this week to ask if she was invested in mutual funds. She’d heard they were high cost and not the place to be. While the call was a little disconcerting given that we only use our own funds to build client portfolios, it was not surprising. Her question reflects a commonly held view that says, “give me anything but mutual funds.”

It was interesting timing nonetheless, because I happened to be reading a report on mutual fund fees published by the Canadian Securities Administrators (CSA), the umbrella organization for the provincial and territorial regulators. It sounds boring, but as regulatory documents go, this one is a page turner. It delves into how fees are charged (many ways) and what clients know about them (very little). While it’s diplomatic and measured in tone, the paper goes straight to the industry’s worst practices. The further I read, the better it got (I know, get a life).

You may be surprised by my enthusiasm, but regular readers will know that I’ve never been shy about probing the industry’s soft spots – high fees, compensation conflicts, a focus on chasing short-term trends, high manager turnover and opaque reporting. With respect to the CSA paper, I’m particularly excited for two reasons. First, it broadens the discussion to include not only fund manufacturers, but distributors too. And second, it’s a strong, well-researched document that gives me confidence that positive change is coming.

I say “broaden” because, after just a few pages, it becomes obvious that mutual funds per se are only part of the problem. Indeed, the things that investors dislike about funds for the most part relate to how they’re distributed. The paper points out that, “91 per cent of investment fund assets were acquired and held by investors through distribution channels involving the intermediation of an adviser.” It then describes the conflicts of interest that advisers face and breaks out the share of management fees that go to pay trailing commissions (about half on average).

While there’s been some give on fees by the fund companies (not much, but some) and there’s pressure to do more, the distributors’ share of clients’ returns hasn’t yet budged, and seems to go unnoticed. For example, trailer fees have not been reduced, and in some cases have been increased to promote the sale of new products or dealers’ in-house funds.

From my observation, the advisers’ response to increased fee awareness has been to use lower-fee products (ETFs and model portfolios) to bring down clients’ overall cost, rather than reduce their own fee. The largest so-called variable cost in the mutual fund equation – sales compensation – has been stubbornly fixed.

As for my optimism around change, the CSA paper is so revealing that it’s hard to see how regulators and the industry can go forward without making substantive improvements. A document that includes seven pages of potential conflicts has a way of raising expectations.

My one concern about the paper is that it focuses solely on mutual funds, and yet the issues it probes apply to other types of products too. When stricter rules come down on fund distribution, there’s a good chance investment flows will simply shift to other less regulated areas, where I would suggest conflicts and fees are even bigger issues (for example, principal-protected notes, guaranteed income products and closed-end funds). This shift is called “product arbitrage.”

As I said in the fall when I wrote about the impending improvements to fee and performance disclosure, the next couple of years are going to see profound change in the wealth management industry. The ducks are lining up. There’s a groundswell amongst investors, the CSA is on the bit and the mysterious mutual fund maze no longer fits with a connected world that values transparency and fairness.

Good players won’t have a problem dealing with the changes. Their clients will likely shrug and say, “Whatever. I’m getting good service, and now I know what I’m paying for it.” The ones who need to worry are those who are dancing around the conflict of interest line, collecting fees for advice they’re not providing and/or not being forthright with their clients.

If increased scrutiny of Canadian mutual fund fees is a way to shake down the whole system, I’m all for it. Let the change begin.