An end to trailer fees?

The regulators want to look at whether advisor compensation (such as sales and trailing commissions) influence mutual fund sales. If so, the regulators want to know the degree to which these commissions drive sales, as well as insight into how the use of fee-based vs commission-based compensation affects retail investors in terms of costs, asset allocation, product selection and risk-adjusted performance.

The RFP deadline is May 5. The research is expected to help inform the regulators’ decision on whether to ban trailer commissions or otherwise limit them in some way. The RFP indicates that researchers will have six months to complete their work.

This initiative represents the next step in the regulators’ examination of mutual fund fee structures that began back in 2012. Late last year, the CSA said that further research is needed to reach a decision in this area. The OSC aims to reach a policy decision on the subject by early next year.

The question of whether advisor compensation structures drive mutual fund sales is not a new one for regulators. In 2004, the OSC pledged to study the same issue as part of its fair dealing model (FDM) initiative. The original FDM consultation paper stated that the economists at the OSC were building an econometric model of mutual fund assets under management, asset performance and advisor compensation in order to: compare the role of compensation vs investment performance as a driver of fund sales; determine the extent of any conflict of interest in the client/advisor relationship; and, ultimately, to quantify the impact of any bias.

Julia Dublin, who ran the FDM project at the OSC and now is in private practice at her own law firm in Toronto, recalls: “The idea was to put a number on the ‘conflict premium,’ as we called it.”

However, that research was never actually carried out. There was some disagreement within the OSC, Dublin says, over whether a grand statistical analysis is the best way to understand the issue. She maintains that the case studies used in the original paper are as “compelling” as statistical analyses – if not more so.

The OSC’s FDM paper included four case studies that examined various ways that embedded compensation structures can hamper transparency and lead to biases that affect retail investors. Dublin recalls that the econometric modelling approach was never officially ruled out: “It just faded away.”

In the years since then, various academic studies have tackled the question of the effects of advisor compensation on investors’ decisions and results. This research, mostly in the U.S. market, has uncovered evidence of bias that affects investors.

For example, a 2008 paper from the China Europe International Business School found that investment funds with higher sales charges (a.k.a. loads) and 12b-1 fees (the U.S. equivalent of trailer fees) tend to receive greater flows, thus “showing evidence that there exists conflicts of interest between load-fund investors and brokers and financial advisors.”

This paper states that brokers and advisors “apparently serve their own interests by guiding investors into funds with higher loads and 12b-1 fees, which generate higher income to the brokers and financial advisors but increase the expenses of investors.”

Similarly, a 2013 paper for the Journal of Finance submitted by three academics, including an associate professor at the University of Toronto’s Rotman School of Management, found “significant effects” of payments to brokers – again, in the U.S. – on funds’ inflows. That study also found a correlation with poor fund performance.

According to this paper: “New investment increases with the load paid to the broker, in particular when the brokers are unaffiliated, and similarly, future performance decreases with the brokers’ payment from the load, particularly when the brokers are unaffiliated.”

These results do not augur well for defenders of current compensation structures, although it remains to be seen if the research for the CSA will find the same sorts of effects.

Now that the CSA is broaching this question once again, Dublin says, the research’s design will be critical. “If there are too many assumptions, or the fudge factors are too large, the results won’t be meaningful,” she cautions. “What was nice about [the case studies used in the FDM paper] was that there wasn’t much noise – the only variable was the higher compensation paid under the [deferred sales charge] version of the fund.”

Back in 2004, one of the impediments to the OSC’s research was the lack of data. This time around, the industry probably will be pushed to participate. According to the RFP, the data for this research are likely to be sourced directly from investment fund managers – and the regulators will require firms to provide this data.

After the data are collected and analyzed, a draft report will be produced that sets out the preliminary results, on which the OSC will provide feedback.

Then, a final, public report will be prepared that sets out the findings, assesses the implications (costs and benefits) of these results to investors and the industry, and provides an independent assessment of what the findings mean to the Canadian investment fund market overall.

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