There is a fundamen-tal divide in Canada’s asset-management business between firms that keep manufacturing and distribution strictly separate, and others that have taken the plunge and married the two. For now, the integrated firms appear to be winning, but the spectre of conflict looms.

Consider the U.S. market. Earlier this year, brokerage giant Merrill Lynch & Co. Inc. decided to sell its asset-management business to money manager BlackRock Inc. Merrill’s move followed a deal between Citigroup Inc. and Legg Mason Inc. , which essentially saw Citigroup trade its money-management business for Legg Mason’s dealer business.

The transactions are viewed by some as the start of a trend in the U.S. toward pure plays, primarily as a way to avert the conflicts that are inherent in firms that offer both independent distribution and proprietary products. Because the U.S. industry is often a leading indicator of trends that eventually migrate north, it’s worth wondering whether Canada’s industry, too, could revert to the pure play model.

Disparate views on the subject were aired at a recent industry conference hosted by Scotia Capital Inc. in Toronto. Not surprising, executives of the firms that are exemplars of the different models took opposite sides of the issue.

AGF Management Ltd. chairman and CEO Blake Goldring suggested the U.S. trend will continue and that the Canadian industry will follow suit and separate the businesses. CI Financial Inc. president and COO Stephen MacPhail, however, insisted that owning distribution channels remains a compelling advantage.

There is no doubting that, in the past few years, firms with captive distribution have been more successful than those without it. The bank-owned fund companies, particularly RBC Asset Management Inc. , have dominated sales charts. Not coincidentally, they also have an overwhelming distribution advantage.

Bank-owned firms control about 60% of the distribution channels, as measured by assets under management, according to a recent report by CIBC World Markets Inc. , including branch sales, branch-based advice, discount brokerage and full-service brokerage. Traditional fund dealers account for about 27% of AUM, with the rest controlled by direct sellers, institutional and private-client sources.

Among the independents, the ones that have enjoyed strong sales — CI and Dynamic Mutual Funds Ltd. , for example — also have various affiliated distribution. Many of the larger firms that don’t have captive distribution have had their sales struggles of late.

Vertically integrated asset-management firms used to be the exception in Canada. The prevailing model during the industry’s strongest period of growth in the mid- and late 1990s involved independent companies selling their wares through a variety of independent dealers. When growth slowed, however, consolidation became the strategy on both sides of the business. The dealers were driven together by escalating technology costs and regulatory demands. The need for scale pushed the manufacturers to merge. Then they began courting one another.

Some of the industry’s bigger thinkers saw the appeal of integrating manufacturing and distribution. Asset management is more profitable, and more highly valued, than distribution. But built-in distribution can ensure continued growth in the precious asset-management business, regardless of the external sales environment. The logic becomes even more powerful as the dealers consolidated and shelf space has been dramatically reduced.

The danger in putting the two sides of the business together is that the industry runs the risk of hurting both. Clients might be turned off by the obvious conflict when proprietary products are being pushed to them; other dealers might stop selling a manufacturer’s funds once it effectively becomes a competitor in the distribution business.

These fears have largely proved to be unfounded. Clients either don’t notice, or don’t care. And independent manufacturers that either have bought distribution (CI) or have been bought by it (Mackenzie Financial Corp. ) seem to have managed the transition without alienating many of their traditional dealers. The original financial supermarkets, the big banks, have become serious about building their fund businesses, and their success has reinforced the notion that the two sides of the business can survive under one roof.

Indeed, the result of the shift is that the five largest firms in the industry today — IGM Fin-ancial Corp. , RBC, CI, TD Asset Management Inc. and CIBC Asset Management Inc. — all have some form of in-house distribution.

@page_break@It would seem, then, that the question is settled as far as the Canadian industry is concerned. Guaranteed access to distribution is a powerful competitive advantage, particularly when overall sales are rather weak when compared with the industry’s glory days.

But could we yet revert to the pure play model that seems to be re-emerging in the U.S.? For the most part, analysts doubt it.

“I don’t think that Canada will follow the U.S. in separating manufacturing and distribution, as the marketplace is different,” says Genuity Capital Markets analyst Karin Huo in Toronto. “In Canada, some of the largest fund companies are bank-owned. And the main reason for their success is due to their distribution channel.”

Stephen Boland, analyst with CIBC World Markets Inc. in Toronto, says the question must be considered from both the regulatory and business perspectives. Much of the pressure to separate the businesses in the U.S. came from an increasingly hostile regulatory environment, in which the obvious conflicts became increasingly intolerable, Boland says: “I don’t think Canada will become as punitive as the U.S. environment.”

Dan Hallett, president of Wind-sor, Ont.-based fund industry analyst Dan Hallett & Associates Inc. , agrees: “Clearly, Canadian regulators have no problem with integrated dealer/manufacturer structures. I don’t see a sep-aration happening in Canada unless the industry is hit with a big scandal in which such integrated structures prove to be a real problem.”

If the regulatory environment isn’t going to encourage a return to the pure play model, what about the business climate?

Boland says the ad-vantages of vertical integration are a somewhat cyclical phenomenon.

“There are times when owning distribution makes sense, and probably a time when it doesn’t,” he says. “Owning distribution right now makes sense, since it provides an advantage to the manufacturer to gain assets under management over competitors in this moderate sales environment.”

In times of rapid growth or material redemptions, he adds, owning it may be a strain or hindrance.

Indeed, even in the current climate, some firms may not want the operational distraction that comes with owning distribution, which has never been much of a money-maker. Back when the pure play model prevailed, dealer businesses weren’t really expected to make money as a corporate entity. Rather, they were operated by advisor/managers who were still running their own books of business, and who looked at their books as their livelihood. The dealer was largely a name on the door and a back-office function.

When asset managers were able to add assets with relative ease, they didn’t know much about the distribution business and didn’t have much interest in owning part of a highly fragmented, minimally profitable enterprise. Even today, when firms have little in the way of new sales, some would rather just stick to their knitting.

For example, earlier this year, Montreal-based Standard Life Financial Inc. , citing its desire to focus on its core business of product manufacturing, sold its distribution network, Performa Financial Group Ltd. , to another Quebec-based giant, Desjardins Sécurité Financier.

Hallett says the pure asset managers can still survive in an environment that allows captive distribution: “Marrying distribution and manufacturing under one roof poses huge potential conflicts. Indeed, having captive distribution is very profitable. But the best and most ethical fund manufacturers will respect the interests of retail clients and the independence of their related dealers, and they’ll work to earn shelf space like everybody else. If they can do that, they won’t need to dance on ethical lines to profit from related distributors.”

Genuity’s Huo agrees, noting that as long as the independent firms have good products to sell, “there will always be the independent advisors and brokers” willing to sell their funds.

The advantage of captive distribution is that asset managers may be able to sustain sales even if they don’t have particularly good products. If the current weak sales environment prevails, secure access to distribution may become a more pressing need.

“In the long run, if [pure asset managers] want to grow significantly and compete with the banks, they may need to partner with someone who does have a distribution channel,” says Huo.

Although owning some form of distribution can certainly make life easier when times are tough, it’s not a panacea. All the big banks have distribution, but RBC has clearly been head and shoulders above the rest of the industry in the past few years, in terms of sales. The others have all had their moments of strong sales, but they’ve seen their share of redemptions, too.

Owning distribution is undeniably an advantage, but it isn’t foolproof. IE