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Unfinished business: It's time to end embedded commissions

Tom Bradley is president of Steadyhand Investment Funds Inc.

'Our financial adviser is such a nice man. Every year he takes us out for a wonderful dinner. I wish we could pay him in some way."

This is an exact quote from a friend's mother. It's a classic example of a Canadian investor not knowing what he or she is paying.

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Fortunately, Canada is on the verge of making meaningful headway in advancing clients' understanding of their portfolio. In what's been dubbed CRM2 (Client Relationship Model), the Canadian Securities Administrators (CSA) will require by July, 2016 that investment dealers clearly disclose, at least annually, everything the client has been charged (commissions, management fees and administration charges) and provide a full reporting of investment returns.

The CSA is also considering whether to eliminate embedded compensation, or what's commonly known as trailer commissions – an arrangement whereby the financial adviser receives a portion of a mutual fund's fee (usually 1 per cent for an equity fund) as long as the client holds the fund.

A trailer-less world

There are benefits to taking trailers out of funds and having the client and adviser determine a separate payment for advice and service. The main one is that clients will better understand value for service – how much they're paying, what they're entitled to and who is getting paid for what. Research done by the CSA indicated that two-thirds of fund holders didn't know their adviser was receiving a trailer. My friend's mom is not alone.

It also means that advisers will independently evaluate the worth and potential of investment products – no conflicts of interest because of compensation. Canadian portfolios are heavily tilted towards commission-based products (mutual and closed-end funds), whereas ETFs (no trailers) have achieved limited penetration so far.

Eliminating trailers will mean more investors end up where they belong. Too many Canadians pay for investment advice they're not receiving. Too many large investors ($500,000 and over) are not benefiting from the size of their portfolio.

Despite these pluses, however, investment dealers and fund associations are fighting tooth and nail to keep embedded commissions. From the back and forth with the CSA, three main issues have emerged.

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Small investor – No advice

The industry's primary argument for maintaining the status quo is that small investors will not be able to afford advice if it's charged separately. Trailer fees, with their inherent opaqueness, allow dealers to subsidize small clients (presumably by charging larger ones too much). This becomes more difficult to do with increased transparency.

To me, this argument lacks credibility. The dealer community is not the great protector of the small investor, as evidenced by the fact that in most shops the branch manager and compensation structure openly encourage advisers to cull their small clients – pass them off to call centres, bank branches or rookie advisers.

Independents in peril

Everyone is concerned that eliminating trailer commissions will be the death knell for the independent shops that are already struggling to compete with the big institutions. Many dealers rely heavily on trailer fees. There's no easy answer here, but it shouldn't be lost on anybody that the banks' rise to domination has occurred during the trailer-fee era. Perhaps without the trailer subterfuge, we will see new business models emerge, something that Canada has been lacking.

Too much too soon

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Finally, with the industry scrambling to get ready for CRM2, the CSA is being told to slow down. It's too much change at one time. For sure, CRM2 is costing money and taking up management time, but I have no doubt the industry can eliminate trailers, especially if it is given a two- or three-year runway (if this were a new product opportunity, it would be ready to go in weeks). And you can't tell me that in preparing for CRM2, firms aren't developing systems that will work in a trailer-less world. The CSA raised the possibility two years ago.

In light of these issues, my pitch to the CSA is this: In five years, do you really want to be one of the only countries in the world with embedded commissions? CRM2 represents a huge step forward, but without eliminating the complexity and potential conflicts inherent in trailers, it's unfinished business. You've gone through a lot of pain to get this important issue to this stage; it's time to push it over the finish line.

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About the Author
Tom Bradley

Tom Bradley is the President and founder of Steadyhand Investment Funds. His education includes a Bachelor of Commerce degree from the University of Manitoba (1979) and an MBA from the Richard Ivey School of Business (1983).Tom started his investment career in 1983 as an Equity Analyst at Richardson Greenshields. More

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