In early June, the Ontario Securities Commission held a roundtable on mutual fund fees to examine the role of embedded compensation. As a participant, I explained how trailing commissions facilitate access to financial advice for the majority of investors.
People who seek financial advice through advisors generally have better results than those who do not. Investors who seek advice typically outperform do-it-yourself investors, have more invested and are less prone to overreact to short-term market swings.
Read: OSC roundtable participants predict fees could double
To ensure more investors have access to advice, advisors, regulators and investment managers should simplify investing options through progressive legislation and maximize incentives to save for retirement. We must also promote transparency and awareness.
Fee transparency
Regulators have already improved mutual fund fee transparency with the amendments to National Instrument 31-103 that come into force this month.
Once the new cost disclosure requirements are fully implemented in 2016, all investors will know exactly how much they are paying and be able to discuss with their advisor what services they are receiving.
As such, the method of dealer compensation will no longer give rise to a perceived conflict of interest.
Read: Will fee-for-advice cost clients too much?
So what’s driving the push to ban trailing commissions?
Supporters of a ban claim advisors are incented to promote funds that pay the highest trailing commissions. However, compensation does not drive sales – performance does.
In the annual Environics Advisor Perception study, advisors consistently cite product performance as the most important reason for increasing business with a fund company.
Read: Compensation concerns limit advice: CAILBA
Further proof is in industry fund flows.
Since the market downturn in 2008, flows of new money have shifted sharply toward funds with four- and five-star Morningstar ratings, which are based primarily on long-term performance. Of the 2,200 long-term funds available in Canada, about 400 have either four- or five-star ratings.
This group accounts for 100% of industry net flows for each of the past five years.
Even among funds that pay above-average trailing commissions, flows are still correlated to fund performance. Nothing suggests conflicts exist where trailing commission rates are standardized.
Pooled fees and advice
Detractors of embedded compensation also claim small investors are somehow harmed by the arrangement.
On the contrary: smaller investors derive exceptional value when paying a bundled fee for advice. My firm recently surveyed 180 advisors representing more than 25,000 investors across Canada. We asked about compensation, services provided and hours spent on each client. Admittedly, this was a small sample size, so we will expand this survey later this year to include all advisors in our database.
Read: How to frame fees
Our research found that the top 20% of clients (by assets) pay the dealership an average monthly fee of $225, compared to $85 for the remaining 80% of clients. We also found few differences between the services provided to each group.
Clearly, smaller investors benefit from a pooled fee arrangement, which is only possible when compensation is embedded.
What’s more, if embedded compensation were eliminated, fees would likely increase anywhere from 25% to 150% for the average Canadian investor.
Read: Are your fees transparent?
Currently, everyone invested in a fund pays the same rate by law, but if small investors lose that protection, they will have to negotiate fees on their own. In these cases, we know they are never paying less than 1%.
At our firm, the lowest asset-based fee paid by an average retail investor is 1%, but many pay more (1.2% to 1.5%).
Read: Fee-for-advice model lacks transparency: IFIC
In the U.S., Cerulli Associates found investors in fee-based accounts require a minimum account size of $5 million, on average, to lower fees to less than 1% of assets – same as the trailing commission on a typical Canadian equity fund.
Little evidence suggests embedded compensation harms Canadian investors. On the contrary; trailing commissions improve access to advice. While fee-based accounts may benefit affluent clients, they are often more expensive for small investors.
Read: MFDA dealer backs CSA’s mutual fund fee proposals
Given the transparency provided by NI 31-103, whether an investor chooses to pay her advisor through the fund company or out of pocket is not an appropriate matter for regulation.
Ultimately, investors should have choice between embedded fees, negotiated fees, working with a salaried financial planner or investing on their own.
Peter Intraligi is President and COO of Invesco.
What do you think? Sound off in the comments or email us.