As Rudy Luukko wrote in a recent column, the Canadian Securities Administrators considers that "embedded compensation paid by fund companies to dealers -- primarily trailer commissions that are paid on an ongoing basis and point-of-sale commissions on deferred-sales charge funds -- create conflicts of interest, aren't aligned with service levels and limit investor awareness, understanding and control over the costs of advice and service."
The gist of the CSA's Consultation Paper 81-408 - Consultation on the Option of Discontinuing Embedded Commissions is that embedded commissions may encourage investment managers to look at dealers and sales people as their customers, rather than the people whose money they invest. Trailers, rather than performance, are what attract and retain assets. I'm leaning toward agreeing with that premise.
I calculate that the annual value of mutual fund trailers is close to $10 billion, which means a lot is at stake, and I suspect it exceeds the amount the industry pays for portfolio management. For scale, compare that $10 billion with Canadian chicken production of $2.4 billion in 2015 and Quebec maple syrup production of about $300 million. I suspect that more people understand maple syrup and chicken pricing than understand trailer fees.
The argument against trailers isn't new. Glorianne Stromberg's January 1995 report, Regulatory Strategies for the Mid-'90s, Recommendations for Regulating Investment Funds in Canada, prepared for the CSA, made a similar observation regarding fund companies' perception of who is the customer. However, she was reluctant to recommend that trailer or service fees be banned, noting that industry participants were concerned that banning trailers "would just encourage sales representatives to increase the transactions within their clients' accounts or to abandon their clients after the initial sale." That, of course, was long before robo-advice and the ETF selection available today, which allow even small investors access to expertise at a lower cost than with mutual funds.
Until late 1989 and early 1990 most mutual funds were sold with a front-end load, which was typically 9% on a purchase of less than $25,000. This didn't apply to funds sponsored by banks, trust companies and a handful of fund companies that sold directly to the public on a zero-commission basis.
Because of competition from the no-load organizations, fund companies selling through dealers switched to declining deferred redemption fees with ongoing trailers. Sales people routinely told clients that they didn't pay a commission because the dealer was compensated by the fund company, and so long as they held for seven years they wouldn't pay a fee. Of course, the management fees charged by these fund company were significantly higher than the fees charged by no-load companies, the difference reflecting the trailer and the amortized cost of the 5% or so commission the fund company paid to the dealer at the point of sale.
As I noted in this column several years ago, in 1994 the Investment Funds Institute of Canada convinced the CRA to treat trailers as a GST-exempt financial service or commission. The CRA changed its mind in late 2009, noting activities performed by an advisor after the sale that make trailers a GST/HST taxable service. These include:
- Regularly meeting with or contacting the client to review the status of the account and the appropriateness of the units held in the account in light of the investor's financial needs and investment objectives;
- Ensuring that the client fully understands the nature of the units held in the account and all of the implications of holding the units;
- Answering any questions that the client may have regarding the account, or the units held in the account;
- Recommending any appropriate change in the account or in respect of the units held in the account; and
- Assisting a client in exercising any right or privilege in respect of the account or the units held in the account.
I doubt if many investors would object to reasonable fees as ongoing compensation if their advisors provided these after-sales services. However, many investors hold trailer-paying mutual funds in discount brokerage accounts where no advice is provided. (The fund industry started to address this a few years ago with the launch of D-class units, which pay reduced trailers and are intended for the discount brokerage market, but only a handful of fund companies offer them.)
A significant issue, however, is that trailers apparently are not used primarily for the benefit of the investor. The CSA paper refers to letters received on April 12, 2013, from IFIC and from the Investment Industry Association of Canada--two organizations that have a lot of influence and oppose a ban on embedded commissions. The IFIC letter says that "trailing commissions are paid to the dealer firm to cover a whole host of regulatory and supervisory functions and services in addition to advisor compensation. The dealer may retain one half or more of the trailing commission to pay for, for example: tier 1 and tier 2 supervision and the systems that support it, regulatory costs including fees to fund the SROs, OBSI, and securities commissions, client complaint handling processes, advisor investigation and enforcement requirements, general compliance obligations of the SROs, OBSI, and securities commissions, client reporting, due diligence on products, etc."
However, elsewhere the CSA paper quotes a 2014 IFIC document titled Paying for Advice: Why Options are Important, which says that, "on average, 0.78% of the assets invested in a long-term fund are paid annually by the fund to the dealer, of which approximately two-thirds may go to the representative for advisory services and the rest kept by the dealer to pay for administrative, compliance and regulatory oversight functions." An Investors Group submission gives a slightly different view, indicating an industry average of two-thirds of the trailing commission actually paid to advisors as deferred compensation for the initial advice and for ongoing service provided by the advisor to the client. It points out that level of client service varies.
So, combining the information in the two IFIC documents, two-thirds of the trailer may go to the representative for advisory services and the remaining half or more will cover administrative stuff.
The IIAC letter states trailing commissions support "Printing and mailing of disclosure documents (prospectuses, Fund Facts, other shareholder communications, including proxy material); Processing of corporate events and distributions (Since mutual funds held by investment dealers are typically registered in nominee name, the dealer takes on responsibility for updating client account records for things such as mutual fund reorganizations and client payments of interest, dividends, etc.); Preparation and distribution of tax reporting information such as annual trading summaries, and, in some cases, T3 and T5013 tax slips; Provide the widest selection of mutual funds from multiple fund families (This requires efforts by the dealer/advisor to conduct extensive product due diligence and legal documentation before making these funds available to clients.); Custody services; Portfolio monitoring of margin requirements; Clearing and settlement of purchase and sales through FundSERV and/or CDS."
So, if you take the 0.78% of assets noted in the paper and use a $1.2 trillion value for mutual funds noted in the CSA document the value of trailers approaches $10 billion. Even half that amount is a lot of money for printing, mailing, tax slips, etc., and the laundry lists these industry organizations provide seems to confirm the CSA's concerns that trailers create conflicts of interest.
