It’s been more than two decades since regulators raised concerns about embedded commissions, but a new discussion paper from the Canadian Securities Administrators suggest investors will have to wait a little longer before that changes, despite added evidence of the negative impact of those commissions.
It was back in 1995 when Glorianne Stromberg, then chair of the Ontario Securities Commission, first argued embedded commissions create a conflict of interest that misaligns the interests of the investment fund industry and investors. On Tuesday, the Canadian Securities Administrators released its latest consultation paper on this issue to review the options. While the paper doesn’t yet change the way advisors are paid, it presents the strongest case to date for why the investment industry needs to change and offers glimpse of how the industry will look once these commissions eliminated.
“Regulators have taken far too long,” says John De Goey, a portfolio manager with iA Securities, who questions why it’s taken more than 20 years for regulators act on the evidence that embedded commissions run counter to investor interests. Still, De Goey sees the latest report as a sign that progress is being made. “They are rolling up their sleeves instead of just asking questions; they are finally acknowledging they have evidence,” he says.
Commissions continue to influence product sales
That evidence is on full display in the latest report. The most alarming finding within CSA paper is that investors are being steered into these products because they pay embedded commissions to advisors. The CSA notes 87% of investment fund managers offering actively managed funds have products with negative alphas, or a measure of their performance relative to the benchmark. It goes on to say that these products are at risk of redemption if embedded commissions are eliminated, yet front-end load funds, which charge an extra commission when you buy the fund, continue to be sold at a high rate.
At the end of 2015 there more than $298 billion worth of front-end loaded funds were purchased. That’s an increase of 93% over the past five years and represents almost a quarter of the market. Even back-end loaded funds, which have been falling in terms of market share, remain a significant segment of the market. Sales of back-end loaded funds grew 19% to $241 billion over the past five years.
Overall, the CSA estimates 44% of assets currently invested in actively managed funds could be reallocated if embedded commissions were eliminated and managers are not able to adjust their fees or improve performance.
How regulators plan to eliminate commissions
The discussion paper also narrows down its focus on how it plans to eliminate embedded commissions. What’s clear from the discussion paper is that regulators are putting the onus on the industry to determine the best compensation arrangement for their business and clients.
Under the new direct pay arrangements the CSA expects dealers will either opt to be compensated through upfront commissions (similar to front-end sales loads), through hourly fees, flat fees or a fee based on the client’s portfolio size. There may be other options as well, provide the compensation in connection with the purchase of a security or other service is negotiated and agreed to by both the investor and dealer.
In response to earlier discussion papers some within the industry have argued that this approach is untenable. They argue that will create disparities between how much investors pay for advice. They also argue investors lack the knowledge to negotiate these fees. In some cases investors, particularly those with smaller accounts, will no longer receive any advice once trailing commissions—an ongoing fee directly from the fund company which has been criticized as providing an incentive to the advisor to sell their products—are eliminated.
De Goey, for one, doesn’t by into these arguments. While he concedes investors may not be able to negotiate fees, they could price shop. Using his own practice as an example, he explains it would be impractical for him to offer 100 different fees. What he can do is offer a fee schedule to show prospective clients how much they would pay to help them determine value. Investors will have the ability to interview me and two or three others to find out what they will get for those fees. “Up until right now, most people have been unaware at what they are paying,” he says.
Rise of the robots
Regulators expect the elimination of trailers will likely drive up the cost of advice, although they argue the level of service and advice will be more in line with the costs paid by investors. This could likely be a boon to robo-advisors. While robo-advisors are relatively new and small in size they still they can offer clients with smaller portfolios some advice and guidance at a low fee. Index funds would be another winner, as more investors into most cost-effective index funds, which have outperformed active managers.
While the CSA maps out its plan to eliminate embedded commissions it is also nixing several options previously under consideration. Some of the options now off the table include separating out trailing commissions and other embedded sales charges from the management fee, capping commissions and requiring a standard class for DIY investors that offers reduced or no trailer commissions.
Commissions will not be eliminated overnight
The CSA will be taking submissions until June 9. It will take a considerable amount of time to go through those submissions, says De Goey. He doesn’t expect there will be any more movement on this topic before the end of the year.
Even if the CSA does enact a policy on trailer commissions it will be years before they will completely disappear. According to the CSA it will take up to 36 months to phase out commissions once a new policy is put in place. Funds that already had a deferred sales charge would be allowed charge that fee until their schedule ran out. This would give fund companies time to developed and implement direct pay arrangements with their clients.