As mentioned yesterday, I received a query from an Assiduous Reader asking me to clarify my remarks of December 13 regarding the recent CSA Discussion Paper and Request for Comments on Mutual Fund Fees.
Having reviewed my comments, I confess to some surprise that clarification should be required – they seem plain enough to me. But here goes:
i) The CSA is concerned that:
investors have no say in the extent to which their mutual fund assets are used to pay for advisor compensation.
I pointed out that this is like every other product sold to retail. When I buy a can of beans for $2.49 at the grocery story, I have no say in how that $2.49 is split between the producer, the middlemen and the store itself. Why should I? The deal’s right there: $2.49 for a can of beans, take it or leave it. What’s wrong with that? The price is disclosed and the nature of the product is disclosed: it makes no difference to me whether the Chilean farmer who planted and harvested the beans gets a nickel or quarter out of the deal.
Some people, of course, get all worked up about things like this and start “Fair Trade” organizations with the stated intent of increasing the proportion of the retail price paid to the producer, even if this increases the retail price. Well, more power to them! But most people don’t care because the question is totally irrelevant to them.
As far as mutual funds are concerned – the amount to be taken from the fund by the sponsor as management fees is stated in the prospectus and this figure is (as pointed out by Assiduous Reader mclachlan8) widely publicized. What happens to the fees afterwards is irrelevant to the investor.
ii) I found the following bland assertion rather breathtaking:
Using fund assets to pay for trailing commissions could encourage additional sales of the fund. This could increase the fund’s assets under management, which would increase the management fees payable. This creates an actual or a perceived conflict of interest between the mutual fund manufacturer and the fund’s investors. [footnote]
[Footnote reads:] G. Stromberg, supra note 81, at pages 16-17, comments on this conflict of interest as follows: “A result of this perspective is that independent investment fund organizations have increasingly become marketing companies, more focussed on gaining market share than on being investment management companies focussed on managing investment funds for the benefit of the investors in these funds. The major concern that arises from the focus on marketing considerations is whether marketing considerations are prevailing over investment management decisions and resulting in conflicts of interest between the fund manager and the fund investors.
One reason this is breathtaking is lack of a logical connection between the footnote and the text. Ms. Stromberg was concerned about investment management decisions, which do not have anything to do with the level of fees charged.
An example of an investment management decision that could be influenced by marketing considerations is the decision to invest in security XYZ because it was popular with retail; or because it enabled the marketing department to trumpet the holding as a bold example of incisive logic; or some such rationale. If this rationale conflicted with the portfolio manager’s honest opinion of security XYZ as an investment – yes, that’s a clear breach of duty, that’s bad, take them out and shoot them.
But it has nothing to do with the fee charged.
However, the most offensive portion of the chain of thought lies in the implication that fund assets are used to pay trailer fees. This is, generally speaking, false: fund assets are not used to pay trailer fees. Fund assets are used to pay the Management Expense Ratio; once this payment has been received by the fund sponsor, the funds become property of the sponsor and lose their identity as fund assets. And the fund sponsor is perfectly entitled to do whatever it wants with its property.
There are some rare cases in which fund assets are used to pay trailers: for instance, CPD.A differs from CPD in that the former pays a trailer to the advisors of the holder. This is fully disclosed in the prospectus and reported in the financial statements – I fail to see any problem with this. The payments are included in the reported Management Expense Ratio, and investors can take it or leave it, as they see fit. One of the CSA’s proposed changes [# (iii)] envisions all mutual funds having such a carve-out of trailers … but this is a proposed CHANGE, not a reflection of the current state of affairs.
iii) However, the CSA logic becomes even more convoluted – and even more offensive – in the latter part of the paragraph quoted:
This practice could put the mutual fund manufacturer at odds with its statutory duty to act in the best interest of the mutual fund [First Footnote] to the extent the mutual fund manufacturer, rather than the fund and its investors, is the primary beneficiary of the fund’s asset growth. The mutual fund manufacturer must be able to demonstrate that it is acting in the best interests of the mutual fund and its investors, and not itself, when engaging in this practice.[Second Footnote]
[First Footnote reads] See s. 2.1 of National Instrument 81-107 Independent Review Committee for Investment Funds, which requires the manager of the investment fund to (a) act honestly and in good faith, and in the best interests of the investment fund, and (b) exercise the degree of care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances. The Securities Acts of most of the CSA jurisdictions also contain a similar provision.
[Second Footnote reads] A mutual fund manufacturer could demonstrate this, for example, by reducing the management fees and expenses it charges to a mutual fund as its assets grow, thus yielding a benefit to the fund and its investors. Interestingly however, U.S. studies on trailing commissions, known in the U.S. as “12b-1 fees”, have concluded that trailing commissions don’t yield the expected benefit for investors. When 12b-1 fees were originally adopted in the U.S., mutual funds were experiencing net redemptions. The belief was that if fund flows could be attracted through the use of 12b-1 fees, existing investors would benefit through lower expense ratios as assets under management increased. Subsequent U.S. experience has shown this not to be the case with 12b-1 fees increasing expense ratios on a one-for-one basis even as assets under management increase. See S. Collins, The Effect of 12b-1 Plans on Mutual Fund Investors, Revisited (March 2004) ICI working paper, and L. Walsh, The Costs and Benefits to Fund Shareholders of 12b-1 Plans: An Examination of Fund Flows, Expenses and Returns (June 2004) SEC discussion paper available at: http://www.sec.gov/rules/proposed/s70904/lwalsh042604.pdf.
The logic of the part up to and including the first footnote is absurd. It continues the conflation of the roles of portfolio manager and sponsor discussed above. The Portfolio Manager certainly has a fiduciary duty to the fund to exert care and prudence in portfolio management – that much is basic. But this is an entirely separate topic from how much is charged for that Portfolio Manager’s care and prudence.
A criminal lawyer, for instance, owes fiduciary duty to his clients. But we don’t (often) see Clayton Ruby work for free, although I’m sure he does his share of pro bono work in the public interest. As a matter of general principle, most people will attempt to charge whatever the market will bear for their services, regardless of what those services might be. And why not? It’s certainly not unethical to ask your boss for a raise, or to find a better paying job.
The premise underlying the last sentence of the quoted CSA paragraph, leading up to the second footnote, is offensive to any conception of justice: “The mutual fund manufacturer must be able to demonstrate that it is acting in the best interests of the mutual fund and its investors, and not itself, when engaging in this practice.” Since when, in Canada, has it been necessary to prove innocence? I assert that it is the regulators, or aggrieved parties, who bear the onus of proving that the fiduciary duty of the portfolio manager has been breached.
iv) With respect to the part (ii) of the “possible changes”:
ii. A standard class for DIY investors with no or reduced trailing commission
Every mutual fund could have a low-cost ‘execution-only’ series or class of securities available for direct purchase by investors. The lower management fees of this series or class would reflect that no or nominal trailing commissions are paid to advisors, in light of the lack of advice sought by DIY investors who purchase and hold securities of this series or class. This low-cost series or class of securities could be made available to investors through a discount brokerage, or alternatively, be distributed directly by the mutual fund manufacturer, in which case the mutual fund manufacturer would need to be registered as a mutual fund dealer.
As I remarked, it’s not clear how the discount brokerages will bet paid for this service; it’s also not clear what the manufacturers’ responsibility to the clients will be for this additional service, or how (if?) they will get paid.
With respect to the discount brokerages, I mentioned yesterday the sabre-rattling that has commenced in the UK, with the discount brokerage Hargreaves mulling over how it should be paid for its services given the pending illegality of trailer fees in the UK. The UK has already passed the damn law, and the resolution of this question is not clear!
v) My last remark was with respect to:
v. Cap commissions
There could be a maximum limit set on the portion of mutual fund assets that could be used to pay trailing commissions to advisors as a way to mitigate the perceived conflicts of interests and the lack of alignment of advisor compensation and services described in Part V. …
I stated that the level of trailers is “just plain none of the regulators’ damn business.”, and stand by that remark. Disclosure? Sure – that’s regulatorary business. Level? No way.
A further problem with the regulatory proposals with respect to trailers has arisen in the comments to yesterday’s post with respect to fiduciary duty. If fees are charged directly by the advisor to the investor, then the advisor will have a fiduciary duty towards that client. This is basic, and is currently embedded in the securities laws in the case of secondary trading, where a commission is paid with respect to a trade and the advisor has a number of explicit duties with respect to that trade, e.g., to seek best execution and not to front-run the order.
Now, if one feels that stockbrokers should have a fiduciary duty to clients, that’s all well and good – but is best addressed under the heading “Fiduciary Duty” rather than “Trailer Fees”. Many of the CSA suggested changes have the effect of imposing fiduciary duty on advisors without being quite brave enough to say the word – which is already the subject of a completely different set of regulatory proposals anyway.
It was a mildly positive day for the Canadian preferred share market, with PerpetualPremiums up 8bp, FixedResets flat and DeemedRetractibles gaining 2bp. Volatility was low. Volume was average.
| HIMIPref™ Preferred Indices These values reflect the December 2008 revision of the HIMIPref™ Indices Values are provisional and are finalized monthly |
|||||||
| Index | Mean Current Yield (at bid) |
Median YTW |
Median Average Trading Value |
Median Mod Dur (YTW) |
Issues | Day’s Perf. | Index Value |
| Ratchet | 0.00 % | 0.00 % | 0 | 0.00 | 0 | 0.0934 % | 2,484.1 |
| FixedFloater | 4.22 % | 3.58 % | 32,141 | 18.11 | 1 | -1.1429 % | 3,809.3 |
| Floater | 2.80 % | 2.99 % | 59,979 | 19.76 | 4 | 0.0934 % | 2,682.2 |
| OpRet | 4.65 % | 2.61 % | 53,765 | 0.50 | 4 | -0.2103 % | 2,586.6 |
| SplitShare | 4.64 % | 4.71 % | 59,896 | 4.40 | 2 | -0.0403 % | 2,870.7 |
| Interest-Bearing | 0.00 % | 0.00 % | 0 | 0.00 | 0 | -0.2103 % | 2,365.2 |
| Perpetual-Premium | 5.24 % | 1.61 % | 71,581 | 0.80 | 30 | 0.0767 % | 2,325.6 |
| Perpetual-Discount | 4.85 % | 4.88 % | 132,374 | 15.59 | 4 | -0.0406 % | 2,635.7 |
| FixedReset | 4.94 % | 2.99 % | 228,049 | 4.32 | 77 | -0.0045 % | 2,451.6 |
| Deemed-Retractible | 4.90 % | 2.69 % | 117,019 | 0.42 | 46 | 0.0169 % | 2,415.0 |
| Performance Highlights | |||
| Issue | Index | Change | Notes |
| BAM.PR.G | FixedFloater | -1.14 % | YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2042-12-18 Maturity Price : 22.89 Evaluated at bid price : 22.49 Bid-YTW : 3.58 % |
| FTS.PR.H | FixedReset | 1.35 % | YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2042-12-18 Maturity Price : 23.68 Evaluated at bid price : 25.59 Bid-YTW : 2.72 % |
| Volume Highlights | |||
| Issue | Index | Shares Traded |
Notes |
| ENB.PR.T | FixedReset | 290,771 | Recent new issue. YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2042-12-18 Maturity Price : 23.11 Evaluated at bid price : 25.05 Bid-YTW : 3.76 % |
| MFC.PR.J | FixedReset | 144,095 | Recent new issue. YTW SCENARIO Maturity Type : Call Maturity Date : 2018-03-19 Maturity Price : 25.00 Evaluated at bid price : 25.36 Bid-YTW : 3.74 % |
| POW.PR.C | Perpetual-Premium | 124,480 | TD crossed 94,000 at 25.55. YTW SCENARIO Maturity Type : Call Maturity Date : 2013-01-17 Maturity Price : 25.00 Evaluated at bid price : 25.60 Bid-YTW : -10.69 % |
| POW.PR.D | Perpetual-Premium | 122,320 | TD crossed 109,300 at 25.25. YTW SCENARIO Maturity Type : Call Maturity Date : 2014-10-31 Maturity Price : 25.00 Evaluated at bid price : 25.27 Bid-YTW : 4.92 % |
| SLF.PR.G | FixedReset | 62,610 | National crossed 50,000 at 24.30. YTW SCENARIO Maturity Type : Hard Maturity Maturity Date : 2022-01-31 Maturity Price : 25.00 Evaluated at bid price : 24.32 Bid-YTW : 3.55 % |
| BMO.PR.K | Deemed-Retractible | 44,010 | Scotia crossed 30,000 at 26.32. YTW SCENARIO Maturity Type : Call Maturity Date : 2013-01-17 Maturity Price : 26.00 Evaluated at bid price : 26.32 Bid-YTW : -5.92 % |
| There were 34 other index-included issues trading in excess of 10,000 shares. | |||
| Wide Spread Highlights | ||
| Issue | Index | Quote Data and Yield Notes |
| BAM.PR.C | Floater | Quote: 17.50 – 18.50 Spot Rate : 1.0000 Average : 0.5788 YTW SCENARIO |
| GWO.PR.I | Deemed-Retractible | Quote: 24.56 – 24.85 Spot Rate : 0.2900 Average : 0.1927 YTW SCENARIO |
| MFC.PR.E | FixedReset | Quote: 26.20 – 26.46 Spot Rate : 0.2600 Average : 0.1737 YTW SCENARIO |
| TD.PR.I | FixedReset | Quote: 26.79 – 27.00 Spot Rate : 0.2100 Average : 0.1432 YTW SCENARIO |
| MFC.PR.C | Deemed-Retractible | Quote: 24.10 – 24.29 Spot Rate : 0.1900 Average : 0.1262 YTW SCENARIO |
| BAM.PR.J | OpRet | Quote: 26.56 – 26.73 Spot Rate : 0.1700 Average : 0.1117 YTW SCENARIO |
Agreed James.
The fact is, there are questionable products and processes beyond the world of mutual funds. The banks, as an example, screw their customers with lame products such as PPN’s and index-linked notes. Their discount brokerages make tidy sums from US to Cdn dollar conversions, especially in RSPs. We don’t have to buy their products, and in many cases, we shouldn’t. But we do. It all boils down to consumer interest.
All the information is out there. And it has been there for years. If people don’t wish to study the information, then they get what they deserve. The financial industry understands this, and profit is there to be made from ignorant (disinterested ?) consumers. Just ask the tobacco companies.
You can legislate seat belts, but there are still plenty of stupid people who don’t heed the advice.
Yes. Another thing that gets on my wick is the promotion of stop-loss orders by the discount brokerages. But you can’t save people from themselves!
One of the really bad things I observe about trailer fees and conflicts of interest is that when the trailer fee runs out (after 5 or 7 years), the advisor then recommends that the client move to a different “better performing” fund. Better for him, that is because he resets the clock on his trailer fees. I’ve seen a brother do this to his sister it is so ingrained in the industry — he might lose his job if he didn’t rotate the customer into something providing revenue for the firm.
Another thing I find about trailers is that the prospectus is often not clear on the total fees being charged. They might be mentioned in different places in different names and amounts that are additive (or not), so the total is not always clear to even the knowledgeable (assuming I fit into that category!)
None of this seems to be directly addressed in the discussion documents you refer to, but I suspect they contribute to the anit-trailer sentiment.
I see it as a balance of power and information problem. James is right about transactions between informed buyers and sellers. I believe most investors are uninformed and either not sure how to become informed or erroneously believe they are well informed (though from conflicted sources). Not everybody has James’ intellect and analytical skills. Most don’t read prospectuses because they are long winded boilerplate and they don’t know what to look for. They count on their “friendly” salesman to tell them what is good for them without realizing the salesman is no different from a car salesman — working primarily for himself or his own firm.
My own (probably controversial view) is that the action of investor advocates and regulators should be to level the playing field by working the “education” side of the equation a lot more in terms of setting rational investing expectations and suggesting, rather than legislating, what a “reasonable” fee is. Of course its controversial…but business as usual has been pretty hard on the investing masses.
Oops, and one other thing. A statement on the quarterly or year-end invididual reports to the effect of how many dollars was charged in fees would be nice and transparent to the ordinary investor. They get it for GST, Airline tickets, car purchases etc. and investments should be no different.
One of the really bad things I observe about trailer fees and conflicts of interest is that when the trailer fee runs out (after 5 or 7 years), the advisor then recommends that the client move to a different “better performing” fund. Better for him, that is because he resets the clock on his trailer fees.
The CSA paper addresses this on page 26 of their document:
I agree that it’s sharp practice, but I also agree with prefhound‘s comment:
They count on their “friendly” salesman to tell them what is good for them without realizing the salesman is no different from a car salesman — working primarily for himself or his own firm.
I see it as coming down to the whole fiduciary vs. salesman issue, and as such is much better suited to the fiduciary vs. salesman debate rather than anything particularly special about trailer fees.
And, as I’ve said before: if people want a fiduciary, there’s lots of them around! Just look for the financial industry guys dressed poorly and starving to death, because retail doesn’t want visible payments! ‘Why should I pay’, Joe Retail asks himself, ‘when the guy from XYZ will do it without sending me a bill?’
Another thing I find about trailers is that the prospectus is often not clear on the total fees being charged. They might be mentioned in different places in different names and amounts that are additive (or not), so the total is not always clear to even the knowledgeable (assuming I fit into that category!)
Well, I don’t read many Mutual Fund Prospectuses, but at at any rate everything gets added into the MER.
My own (probably controversial view) is that the action of investor advocates and regulators should be to level the playing field by working the “education” side of the equation a lot more in terms of setting rational investing expectations and suggesting, rather than legislating, what a “reasonable” fee is.
I’m a bit suspicious of “education” initiatives. As mclachlan8 points out above: All the information is out there. and, in an earlier thread:Given that the same information (ie: MER’s, embedded trailers) has been published a gazillion times in the business press, there simply is no excuse for the so-called ‘investor’ to not understand the process.
You can’t educate people who don’t show up for school! I take the view that educational initiatives, as a general rule, do much more to provide steady work for educators than they do to educate the unwashed masses.
I’m also somewhat dubious of regulatory initiatives that have the explicit goal of helping to save the little guy from himself. That’s getting deep into nanny-state territory. Disclosure? Sure! Prescribed business practices? Errrrr …
That being said, I would support one rule change (although this, again, is more suited to the fiduciary vs. salesman rule): make salesmen describe themselves as salesmen. That MUST BE on their business card, it MUST BE on the client statements, it MUST BE on their websites and it MUST BE their regulatory category. None of this “vice president” and “investment advisor” crap, the only title they’re allowed to have is “salesman”, and it must be found on every business document that has their name on it.
There might be some exceptions to the “only title” rule: for instance, it is entirely possible that I personally would need to have two registration categories: “salesman” and “portfolio manager”. In such a case, I suggest that I be required to list both these titles on my documents.
With respect to the last requirement, I note that salesmen are currently described by the OSC as Dealing Representatives or Advising Representatives (depending on the registration category of their employer). Why not “salesmen”?
Not everybody has James’ intellect and analytical skills.
I submit the above as the understatement of the year.
Adrian