One good thing about the recent market timing scandals is that they have focused attention on the shortcomings in mutual fund governance and oversight procedures.
Although Canadian regulators have promised substantial governance reforms, their proposals have not (at the time of writing) been released. Nor do industry players seem to be talking about what they are doing to strengthen internal controls and oversight procedures.
One area that needs attention is how fund managers handle portfolio transactions for their managed funds. There is little disclosure about the subject or the cost of portfolio transactions. This is despite the matter being rife with conflict of interest and despite portfolio transaction costs being a significant part of the fund’s [total] operating expense.
Ten years ago the handling of portfolio transactions was a hot topic with attention focused on the investment manager’s use of “soft dollars” along with related questions.
These included whether the investment fund was paying too much in commissions, whether the investment fund’s manager and brokers were benefiting at the expense of the investment fund, and whether “best execution” obligations were being met.
There were also questions of whether the fund’s expenses were understated and its performance overstated.
Some people thought “soft dollars” should be banned. Others thought there were benefits to be gained by client portfolios permitting their commission dollars to be used to acquire certain goods and services (such as research and investment decision- making tools) that enhanced the ability of money managers and brokers to identify investment opportunities and improve the portfolio’s return. The term “soft dollars” refers to the use, by investment fund managers and brokers with whom they deal, of that portion of the commission payment that exceeds the cost of executing the trade, to acquire goods and services that benefit their managed accounts. The term also extends to commissions paid on portfolio transactions that investment fund managers direct to brokers (and sometimes to sales representatives) to induce them to sell their managed funds and/or refer clients to them.
This questionable sales practice (which goes by many names including “directed brokerage,” “revenue sharing” and “reciprocal commissions”) was supposedly ended by Canada’s sales code rule in respect of publicly offered mutual funds.
The issue of appropriate use of commission dollars has been the subject of extensive regulatory and industry review. As a result, many controversial practices, including the one referred to above, were curtailed. Once again, the need to revisit the subject has arisen and regulators in the U.S., Britain and Canada are reviewing the matter.
It appears that both Britain and the U.S. will continue to permit the use of soft dollars to purchase execution and research services on a bundled and an unbundled basis, but will require increased transparency, accountability and an audit trail. Canadian
regulators have said they’ll consider the appropriate next steps, if any, based on feedback on their concept paper on which they have invited comments until May 6.
It is important that Canada’s rules be aligned with those in the global marketplace and that the right framework be in place to foster the continuance of competitive capital markets and investment decision-making based on independent research, rather than simply targeting lowest costs. It’s also important the little-understood but emotionally charged issue of the use of commission dollars not result in converting capital costs to income expenses.
It is time instead to make full, true and plain
disclosure of the fund’s total operating costs, not just its management expenses. Good governance demands this. IE
Shed light on portfolio transactions
Canada’s “soft dollar” rules must be consistent with those of the global market
- By: Glorianne Stromberg
- May 2, 2005 April 7, 2019
- 10:10