In December 2012, the Canadian Securities Authorities (CSA) published Discussion Paper and Request for Comment 81-407 Mutual Fund Fees (the “paper”), a document containing a detailed description of the methods used to charge fees to mutual fund holders initially and on an ongoing basis in Canada and comparing these methods to the ones used in the United States, England and Australia. The paper focuses on mutual funds offered by means of a prospectus.
The paper examines, in particular, fairness and investor protection issues that may arise from the use of such methods. It sets the groundwork for a wide discussion with participants in the mutual fund and financial services industries as well as with the general public, who are all invited to submit their comments before April 12, 2013.
The preliminary discussion triggered by the paper will serve as a starting point for public consultations and round tables that are expected to be held throughout the rest of 2013, to be followed, where warranted, by regulatory amendments that will change current practices.
The paper paints a detailed portrait of the types of fees paid by investors purchasing mutual funds, classifying them in two categories. In addition to initial front- and back-end sales charges, there are ongoing fees, such as the management fees charged by a mutual fund’s manager and the fees incurred by the mutual fund itself that are paid out of the fund’s assets (and, therefore, indirectly by the investors).
Out of the management fees paid by a mutual fund to a manager, a trailing commission is negotiated and paid by the manager to dealers as compensation for ongoing services to be rendered to investors while they hold units of the mutual fund.
These trailing commissions, which represented 27% of dealers’ compensation in 1996, rose sharply to 64% of their compensation in 2011. As these commissions are not paid directly to the dealers by investors, retail investors are “seeing” less and less of the cost of distribution. Despite the increase in this form of compensation to dealers, the CSA states it has not observed any commensurate increase in the services that dealers provide to their clients or, indeed, any other benefit.
In years past, and for the various reasons invoked in the paper, front-end sales charges paid directly by investors have progressively been replaced by trailing commissions that investors pay indirectly, often without their knowledge.
Even if trailing commissions are disclosed in a prospectus or fund fact as a percentage of the mutual fund’s assets, the information does not relate directly to the investor’s account. The CSA is sensitive to and aware of the public’s concern over the scope and impact that these hidden fees have on the individual clients’ accounts.
Another concern is the conflict of interest that dealers face when they are deciding whether or not to keep a mutual fund in a client’s account, and they have to choose between the suitability of this investment for that client and the related value of its trailing commission as compared to that of another mutual fund.
Some initiatives have already been implemented, such as CRM II amending Regulation 31-103, which requires the regular disclosure of information on the costs and performance of client portfolios. Another one is a project proposing the imposition of a fiduciary duty on dealers to their clients.
The CSA is now considering following the example set by the United Kingdom’s Financial Services Authority by prohibiting trailing commissions outright, with all of the radical consequences such a measure would have on dealers who, in Canada, increasingly rely on these commissions as a source of compensation.
Other options invoked in the paper include setting a cap on the amount of assets being managed by a mutual fund that can be used to calculate the trailing commission, or determining the minimum services that must be rendered by the dealer in order to earn such a commission. Mutual funds may also be required to create a class of units that is exempted from both trailing commissions and the services related thereto. Finally, requiring separate disclosure and invoicing of trailing commissions by managers to mutual funds is also under consideration.
The CSA expects that comments received on the options proposed in this paper will help it better articulate its position on the various options proposed. Although the deadline for submitting comments is April 12, 2013, very few comments have yet been posted on the CSA’s web sites.
While it is true that none of the proposed options will be adopted any time soon due to the serious consequences to the industry that have to be assessed, this is precisely why industry comments that will guide the CSA towards positive solutions from the very outset will allow the CSA to quickly focus the discussion on the real issues.