Will trailers be parked?June 25, 2018
Last week, the Canadian Securities Administrators (CSA) published proposals to update the regulation governing the practices of advisors. Additionally, the CSA also published a status update on the ongoing initiative to review embedded commissions in mutual funds. We discuss the implications for the ETF industry in Canada.
Conventional wisdom in the Canadian ETF industry is that growth in ETF assets is closely tied to the broad-based industry move towards fee-based business models among investment advisors. This trend appears to be well in hand, partly through the evolution of business practices but also in response to a number of regulatory initiatives specifically looking at trailing fees in mutual funds. The regulatory review kicked off in earnest with the December 2012 publication of a Discussion Paper on the topic of mutual fund fees and subsequent request for comments. The most recent major development was the January 2017 publication of a Consultation Paper openly discussing the possibility of banning trailers altogether.
The specific regulatory moves related to trailing commissions come alongside other initiatives, such as the introduction of Fund Facts documents and annual fee statements under CRM2 and a proposal to introduce a regulatory best interest standard for advisors. This combination of factors appears to have prompted the wealth industry to move towards fee-based business models, which should encourage greater adoption of ETFs (which generally carry no trailers). In fact, the majority of ETF launches in Canada over the past five years have come from issuers adding an ETF product line into their retail-focused product mix in an effort to build relevance among fee-based advisors.
Elsewhere in the world, trailing commissions have been subject to significant regulatory scrutiny. Such payments are banned outright in the UK and in Australia, with significant upheaval in the industry in the wake of these bans. Canadian regulators have been studying this issue taking into account both the experience of other jurisdictions and the particular unique characteristics of the Canadian market.
Trailers curbed, not banned
Last week’s announcement of direction from the CSA provides clarity to industry uncertainty over whether trailing commissions would be banned, as initially contemplated in the January 2017 paper. The CSA’s conclusion is that while trailing commissions will remain permissible, the proposed changes to National Instrument 31-103 (governing advisor obligations) significantly raise the bar for the use of trailer-paying product in client portfolios.
Specifically, the CSA is indicating that:
- A prohibition on the payment of all forms of deferred sales charges (including low-load options) is pending and expected to be published as a rule in September 2018.
- A prohibition on the payment of trailing commission to any dealer which does not assess suitability is similarly pending. This effectively shuts down the ability for direct investing firms to sell A- and D-series mutual funds.
- Rather than banning trailing commissions outright, the CSA is proposing to significantly strengthen the rules around the handling of conflicts of interest between the client and the advisor. These changes are included in the current proposed amendment to National Instrument 31-103.
The decision to continue to allow trailing commissions is certainly controversial in that the topic has largely pitted industry status-quo against the views of certain investor groups. However, the approach taken by the CSA appears to balance this disagreement by significantly increasing the compliance burden for business models that incorporate trailing commissions. In other words, while trailers are not explicitly banned, they may become rare as a result.
Conflict of interest rules with significant reach
The CSA’s Proposed Amendments to National Instrument 31-101 (and the associated Companion Policy) close the loop on a number of reforms previously contemplated to address a range of issues identified by the CSA. In fact, the new rules relating to conflicts of interest and suitability incorporate many elements of the proposals related to regulatory best interest standards and the proposed ban on trailing commissions.
- The proposed new rules stipulate that any existing and reasonably foreseeable conflicts of interests be resolved in the best interest of the client, or avoided altogether.
- Explicitly require advisors to consider factors such as costs in determining client suitability, and moving suitability decision-making to the portfolio-level rather than the individual security level.
- Require that a suitability determination “puts the client’s interest first” (Section 13.3(1)(b) in the proposal).
To bolster the above broad requirements, the Companion Policy associated with the proposed NI 31-103 changes specifically speaks to the topic of trailing commissions, obliquely referred to as “third-party compensation.” The Companion Policy explicitly identifies third-party compensation as a conflict of interest, and notes that firms that wish to receive third-party compensation must demonstrate that their product shelf and client recommendations are made without influence from any third-party payment associated with the security at question.
In practice, we believe this would result in increased due diligence for any product on a shelf which includes embedded commissions. Yes, a firm can continue to operate a trailer-laden product shelf, as long as the decision-making around both that shelf and the use of products points to a favourable outcome to the client as compared to the alternatives. It is entirely possible that this is a compliance burden that many wealth management firms would be reluctant to take on, and as a result the trend towards advisors moving to fee-based practices will continue unabated.
This approach has the advantage of allowing cleaner solutions to situations where clients are ultimately paying less in fees under a trailer model than they would in the fee-based structure of a particular wealth management firm. This can arise in cases where annual fees are subject to minimum fees (which may penalize smaller accounts) or where the trailing commissions charged are generally less than the annual fee structure of a particular advisor. In these situations, the client may be better off through a trailing commission arrangement that is negotiated and understood by both parties.
Additionally, an approach driven by suitability and conflict-of-interest requirements may also have the side-effect of capturing third party payments other than mutual fund trailers, but which have the same effect. In other words, by adopting this mechanism, the CSA is casting a wider net than a simple ban on mutual fund trailers would have.
For all those afraid that the CSA’s moves do not go far enough, fear not; the trend towards fee-based advisory and ETF adoption remains firmly intact.
Trailers may not be banned, but their use will be heavily scrutinized by compliance departments and the individuals controlling product shelf. In our view, the easiest course of action for industry will be to avoid conflicts (be they real or perceived) rather than demonstrate that the conflicts are adequately addressed. This will lead to business models where clients negotiate their advisory fees, and products are chosen on their merits.
We believe these reforms will further level the playing field between mutual funds and ETFs with respect to the distribution of each product category. In that environment, the natural advantages of the ETF structure (the externalization of implementation costs and somewhat lower operating overhead) should result in a continued trend towards ETF adoption in Canada.
For questions or more expert ETF insights, please contact:
Director, Head of ETF Trading
Director, ETF Trading
Managing Director, Head of Portfolio Trading