Research findings expected to impact mutual fund sales model

By Brenda Bouw

Canada’s investment industry is anticipating changes to the mutual fund sales model after new research shows embedded compensation, including upfront fees and commissions paid to advisers, creates “bias” in investing decisions.

The independent research, commissioned by the Canadian Securities Administrators, also shows the practice has hampered the overall performance of the funds.

The potential regulatory changes could include a ban of all or part of the embedded compensation model, which is already prohibited in some jurisdictions such as Australia and Britain.

Experts point to two types of embedded compensation in the Canadian industry: an upfront commission that creates a deferred sales charge and a trailing commission paid as a percentage of assets. These compensation schemes are considered an inducement to some advisers to recommend certain mutual funds to their clients.

The research, led by York University finance professor Dr. Douglas Cumming, shows mutual funds that perform better attract more sales. However, the influence of past performance on sales is “considerably reduced” when fund manufacturers pay sales and trailing commissions.

“As past performance becomes less influential on fund sales, so too is there a reduction in future fund performance,” says the study, titled A Dissection of Mutual Fund Fees, Flows and Performance. It includes an in-depth analysis of mutual fund data between 2003 and 2014.

John DeGoey, vice president and portfolio manager at Burgeonvest Bick Securities Ltd, said the research is the “smoking gun” that provides “clear, unambiguous evidence of a bias” in the current system. He believes the study should give regulators enough motive to end the embedded compensation practice, following in the footsteps of other regions.

“The system is clearly broken and needs to be fixed,” says DeGoey, who is also author of The Professional Financial Advisor, which is about to publish its fourth edition. 

“There is no doubt there will be at least some material change that will move the industry towards greater transparency,” he adds, predicting an announcement in the first half of 2016 that includes a timeline for a full or partial ban.

“I would be shocked if regulators maintained the status quo,” DeGoey says.

Ted Bader, national sales manager at SIA Wealth Management, expects regulators will pay close attention to the research as they consider making changes across the industry, including providing greater transparency on fees. He also hopes the new research, and studies that came before it, will continue to raise awareness among investors.

“I would love investors to be more aware of their power in this whole process,” says Bader. “I think a lot of investors feel powerless because of a lack of information – and they are the ones with the money.”

Bader doesn’t believe the current system is broken. Instead, he says, “it’s about the investment industry aligning with investor interests.”