On December 13, 2012 the Canadian Securities Administrators (CSA) published Discussion Paper and Request for Comment 81-407 Mutual Fund Fees (Discussion Paper) focused on the regulation of mutual fund fees in Canada. The Discussion Paper provides an overview of the roles of market participants in the Canadian mutual fund industry and identifies what the CSA considers to be potential investor protection and fairness concerns arising from certain current mutual fund fee structures. The Discussion Paper also reviews various international regulatory reforms with respect to mutual fund fees, as well as potential regulatory reform options available to the CSA. This Osler Update summarizes the views of the CSA expressed in the Discussion Paper but does not reflect the views of Osler or any of our clients on these issues.
The Mutual Fund Industry Fee Structure in Canada
Mutual fund investors in Canada primarily incur two types of fees: sales charges and ongoing fund fees. Sales charges paid by investors vary depending on the type of mutual fund investment chosen, and may include front-end sales charges (investors pay a sales commission directly to the advisor at the time of purchase); deferred sales charge (investors pay a sales charge at the time they redeem from the mutual fund); and no-load (no sales commissions are paid by the investor).
Ongoing fund fees paid by investors indirectly include management fees, taxes and operating expenses. Management fees typically cover the administration of the fund, portfolio advisory services, and marketing and promotion expenses. Management fees, however, may also include what are known as “trailing commissions.” Trailing commissions are ongoing fees paid by mutual fund manufacturers to advisors1 for the services they provide to investors after the initial mutual fund purchase, including providing investment advice. Trailing commissions are usually paid by mutual fund manufacturers to advisors for as long as their clients hold investments in the manufacturers’ mutual funds, and vary depending on the type of mutual fund (i.e. money market, fixed income, etc.) and the purchase option (front-end, deferred sales charge, etc.) under which the investment is made. Trailing commissions are generally included in a mutual fund’s management fee and are therefore, in effect, paid out of the mutual fund’s assets. On average, trailing commissions account for about one-half of the total management fees charged by Canadian mutual funds.
Current Issues Arising From the Mutual Fund Fee Structure in Canada
The CSA has identified five potential areas of concern to them arising from the current mutual fund fee structure in Canada:
1. Lack of Understanding and Control over Fees by the Investors
The CSA points to recent research indicating that mutual fund investors have very little understanding of how their advisors are compensated. For example, while under securities laws, fee information (including the proportion of management fees allocated to trailing commissions) must be disclosed by mutual funds in the simplified prospectus and the management report of fund performance, studies the CSA refers to have indicated that mutual fund investors, particularly retail investors, do not adequately review these documents and may not necessarily be informed by their financial advisors as to the costs associated with their investments. As a result, their investment decision-making may not take into consideration these costs. Furthermore, as trailer fees are included in the general management fee of the mutual fund, the proportion of the management fee paid out as trailing commission may be changed by mutual fund manufacturers without approval of the security holders.
2. Potential Conflicts of Interest
The CSA is of the view that trailing commissions may create actual and perceived conflicts of interest both for mutual fund manufacturers and for advisors. Since advisors rely on trailing commissions as a key source of compensation, mutual fund manufacturers may face increased pressure to attract distribution on the basis of the amount paid as trailing commissions. Increased trailing commissions may also be expected to increase sales of the fund, leading to an increase in the fund’s assets and in the management fee earned by the fund administrators.
The CSA is of the view that advisors also may have a potential conflict of interest due to the possibility of higher trailing commissions from increased sales of a particular fund. For example, since trailing commissions on equity mutual funds are typically higher than those on fixed income or money market funds, advisors may have an incentive to favour such equity mutual funds in portfolio allocations. Similarly, since trailing commissions on front-end sales charge funds (or series) are generally higher than trailing commissions on deferred sales charge funds (or series), an advisor may be induced to favour the front-end sales charge option. As a result, the CSA is concerned that the investment advice may be driven by commission-based fees that are not aligned with the investor’s best interests.
3. Cross-Subsidization of Commissions
Under certain fee structures used in Canada, all investors in a particular mutual fund (or series) pay the same management fee. However, the proportion of that fee paid out as a trailing commission may differ depending on the type of sales charge paid by each investor at the initiation of their investment (higher trailing fees are generally paid for funds (or series) sold on a front-end basis). Thus, two investors buying the same mutual fund may face different upfront charges and different proportions of the management expense fees may be paid out in commissions to their advisors. As a result, the CSA believes that investors with lower trailing commission ratios subsidize those with higher commission ratios through the management expense fee.
4. Lack of Alignment between Advisor Compensation and Services
While trailing commissions were originally intended to support the ongoing investment advisory services tendered to investors by their financial advisors, given the various factors that may influence trailing commission rates discussed above, the CSA is of the view that there is limited evidence of a clear correlation between the amount of the trailing commission and the level of services the advisor may provide.
5. Limited Options for Do-It-Yourself (DIY) Investors
Often, the series of mutual funds sold by online or discount brokerages are the same series as those sold by other advisors. The management fee of these series therefore includes the trailing commission component and the CSA is concerned that advisors do not refund the DIY investor, which means the DIY investor is paying for on-going investment advice that is not received or wanted. This is not an issue if a DIY investor acquires a discount series with a lower management fee or if the trailing commission is related in some way to the DIY investor.
Current CSA Initiatives
The initiatives proposed by the CSA to date have focused on increasing transparency of investment advisor compensation through disclosure of the relevant compensation schemes.
Through the first stage of the CSA’s Point of Sale (POS) project, mutual funds have been required to make available a “Fund Facts” document to their investors, which provides investors with important information regarding the fund’s expenses and trailing commissions in an abridged format. The CSA has since published a Notice and Request for Comment on the implementation of Stage 2 of the Point of Sale Disclosure for Mutual Funds project, which calls for increased disclosure of the potential for conflicts of interest faced by the investment advisor as a result of trailing commissions.
The CSA has also proposed Phase 2 of the Client Relationship Model Project (CRM2), which calls for advisors to make certain disclosures about expenses directly to investors both at the time of the account opening and annually. These CRM2 proposals are currently in the consultation stage.
International Regulatory Reforms
There have been increased reforms and proposals in recent years in other major international jurisdictions to regulate the way retail investors buy investment funds. For instance, both the United Kingdom and Australia have imposed a ban on advisor commissions set by financial product providers or embedded in financial products. Australia has also imposed a statutory best interest duty on advisors selling financial products. Other similar reforms are currently being considered by the United States and Europe.
CSA Regulatory Reform Proposals
The CSA is soliciting comments on several possible regulatory reform proposals to the mutual fund fee framework in Canada, including:
Specifying and Providing Advisor Services in Exchange for Trailing Commissions. This proposal would both define the purpose of trailing commissions and require advisors to provide a baseline level of services in order to qualify.
Creating a Standard Series or Class of Securities Available for DIY Investors. The CSA is exploring the possibility of requiring mutual funds to offer an “execution-only” series of mutual fund securities that will feature minimal or no trailing commissions.
Unbundling the Trailing Commission Component from the Management Fees. This proposal involves charging and disclosing trailing commissions separately from the management fee in order to enhance transparency of the funds’ expenses. This may also allow for regulation of trailing commissions separately from other management expenses and would require approval from the security holders for any changes to such fees.
Creating a Separate Series or Class of Funds for Each Purchase Option.This proposal is aimed at eliminating cross-subsidization of commission expenses by investors.
Imposing a limit on the proportion of fund assets that would be used to pay trailing commissions. This strategy has been implemented in the U.S., and could serve to mitigate the perceived conflicts of interest and the lack of alignment of advisor compensation and services.
Introducing Additional Standards or Duties for Investment Advisors.The CSA pointed to its recent consultation paper discussing the introduction of a statutory “best interest” duty for investment advisors, which is currently in the consultation stage.
Eliminating the Payment of Trailing Commissions by Mutual Fund Manufacturers Entirely. Inspired by the recent trends in the U.K. and Australia, this proposal would leave determination of trailing commission to bargaining between the investment advisor and the investor.
Implications for Canadian Mutual Fund Manufacturers
If implemented, the CSA regulatory reform proposals may introduce a number of significant changes to the mutual fund industry in Canada. Mutual fund manufacturers may face additional disclosure requirements and may be forced to reconsider the structure and distribution of both new and existing products. An outright ban on trailing commissions may also significantly impact the way mutual fund manufacturers distribute their funds, and alternate compensation models for investment advisors may need to be considered.
Implications for Canadian Advisors
The CSA’s regulatory reform proposals may lead to significant changes to the compensation structures of advisors. Furthermore, advisors may face more stringent obligations to manage actual and perceived conflicts of interest. The regulatory reform proposals also leave open the possibility of future rules mandating negotiation of commissions directly with the investor, thereby significantly altering the current business model of Canadian advisors.
The CSA has invited all interested parties to make written submissions by April 12, 2013. Comments on these proposals are encouraged and we would be pleased to assist you in preparing a comment letter if you choose to submit one.
1 The term “advisor” used in the Discussion Paper is a plain language term that is used in the same way that mutual fund industry participants and members of the public commonly use this term to refer to a mutual fund salesperson. The term “advisor” is not indicative of a mutual fund salesperson’s category of registration with Canadian securities regulators and does not imply registration as an advising representative of a portfolio manager firm with authority to trade for clients on a discretionary basis.