Is a ban on trailers coming?

The report indicates that a ban on trailers is likely for a couple of reasons. For one, regulators are devoting much time and attention to fundamental retail investor protection issues and, the report suggests, regulators will not want all of this effort to go to waste.

For example, the Canadian Securities Administrators (CSA) recently commissioned a couple of independent research reports to examine the impact of industry compensation structures on both mutual fund sales and investor outcomes. At the same time, the CSA also is engaging in a “mystery shopping” exercise designed to test the advice that retail investors receive in the real world. In addition, regulators are still contemplating the need to impose a fiduciary, “best interests” duty upon those who provide financial advice.

“The scope of the probe into investment advice extends beyond mutual fund trailers, which is one of the reasons we think action of some kind is inevitable,” the CIBC report says. “There is simply too much activity to end the work with the status quo as the final answer.”

When Canadian regulators seriously examined these issues previously – during consultations on the Ontario Securities Commission‘s proposed fair-dealing model – the industry wasn’t left undisturbed. Instead, the regulators launched a series of reforms that became known as the client relationship model in a bid to resolve various investor-protection issues by increasing transparency.

The CSA’s 2012 consultation paper on these issues proposes several possible regulatory responses to the problems the existence of embedded compensation pose: from banning trailers outright to capping them or requiring dealers to provide minimum levels of service in exchange for their fees.

The CIBC report suggests that the only alternative that resolves the fundamental conflict of interest between advisors and investors that regulators are worried about is a ban on trailer fees: “We think a ban on trailer fees is the most likely outcome, and that outcome is likely to be announced sooner than most people realize.”

Banning trailers would be in line with recent global trends in retail regulation, the report adds, noting similar measures either recently taken or under active consideration in the U.S., the U.K., Australia and Europe.

Although a ban on trailers is far from a sure thing, the CIBC report suggests that it would not be the end of the world for the mutual fund industry. While industry margins probably would come under pressure from the combination of increased compliance costs and intensified price competition, the primary impact would be on the competitive dynamics. According to the report: “We do not see a massive loss of assets for the advice channels or for the mutual fund industry, but it is likely that there will be customer churn that creates winners and losers among the individual companies.”

Looking at the U.K. – where regulators recently banned embedded compensation and raised industry proficiency requirements, among other reforms – the report notes that the early results from the experience there suggests that overall industry revenue and profits have largely held up in the wake of the reforms. And although the number of advisors in the U.K. has dropped, the number of advisory firms has risen since the reforms were introduced. What has changed is not the size of the retail investment pie, but how that pie is divvied up.

In Canada, a ban on trailer fees could produce similar results, the report suggests: “There will be some market share loss to lower-cost alternatives at the margin, but only at the margin if the industry has a strong product response.”

The more dramatic change is likely to come from within the industry. To that end, the CIBC report says, a ban on trailer fees could boost the impact of existing competitive advantages, such as scale, access to distribution and product diversity and quality. In that case, the winners are likely to be the banks and mutual fund firms – such as CI Financial Corp. – that already enjoy these advantages.

Firms could exploit these advantages further in an environment in which trailer fees were eliminated by intensifying another pre-existing industry trend – client segmentation. Without trailer fees to provide an automatic revenue stream, financial services firms would focus more intently on their wealthiest clients while pulling back even more from smaller clients.

In fact, one of the industry’s central arguments against a ban on trailer fees has been that it could create an “advice gap,” in which wealthier clients are taken care of but less affluent clients can’t afford financial advice.

This is where the banks come in, the CIBC report suggests: “The Canadian bank branch channel is well positioned to service clients no longer suited to the independent advice channel.”

Along with the bank option, investors with less than $100,000 in investible assets also could represent a market for the emerging low-cost, automated services, known as “robo-advisors,” that provide some level of generic advice, the report says: “We see these services becoming increasingly popular, as regulatory change will encourage investors to analyze the cost of advice more critically.”

At the other end of the spectrum, investors with at least $500,000 in investible assets stand to benefit from the elimination of a fee structure that causes them to subsidize service and advice to lower-value clients, the report adds: “Investors who have sufficient assets should benefit from higher-quality service with a more aligned fee structure.”

In fact, the report notes that the elimination of trailer fees is likely to accelerate the pre-existing shift to fee-based advice for these clients, which should provide them with the same level of service at a lower after-tax cost because financial advisory fees are tax-deductible in non-registered accounts but trailer fees are not.

The biggest uncertainty, the report suggests, is likely to be felt by clients with investible assets of $100,000-$500,000, as these clients would have the widest range of options. The wealthier investors in this segment could gravitate toward the fee-based brokerage world. The least affluent or most cost-sensitive either could go the do-it-yourself (DIY), discount brokerage route or explore automated advice options. Yet another option would be to turn to mutual fund dealers for advice, accepting a narrower product shelf for a lower cost than these clients would face from the brokerage industry.

This segment of the market could prove to be a real battlefield for assets, the report suggests, as clients seek out a better deal on advice or experiment with DIY investing. In most cases, though, the report predicts, investors will choose to pay for some level of advice, and those who are prepared to do their investing on their own probably are using discount brokers already.

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