It’s coming in January – the Great Reveal.
“Reveal” is a movie term that documentary filmmaker Nettie Wild once defined for me. It happens when “characters present themselves in one way and then through time (hopefully in front of my camera) they reveal another side to them,” she said.
The reveal I’m referring to relates to new reporting regulations that most investors will see early next year in their statements. Client Relationship Model (version two), or CRM2, requires investment firms to report what clients are paying them. Most Canadians invest with a bank, mutual fund dealer or full-service adviser, but few know what it costs.
CRM2 is shaking up the wealth management industry like nothing I’ve seen in my time in the business. As firms scramble to get ready, one area of intense debate is how mutual funds and exchange-traded funds (ETFs) will be affected.
Most people expect that there will be sticker shock for Canadians who primarily invest in mutual funds. That’s because it will be the first time they see how much of their fund fees are flowing back to compensate their advisers. A vast majority of mutual funds in Canada pay a trailer commission to the advisers who sell them. This embedded commission is generally 1 per cent per year for equity and balanced funds, and lower for fixed income funds.
I say shock because a few years ago the provincial regulators, the Canadian Securities Administrators (CSA), did a survey and discovered that two-thirds of investors were unaware that their adviser was receiving compensation from mutual fund companies. So many investors will go from thinking they pay their adviser almost nothing to, well, something quite different.
Some observers believe that CRM2 will cause investors to leave mutual funds in droves and either buy ETFs or build portfolios using individual securities.
It’s all about services
Unfortunately, it’s more complicated than that. CRM2 is not about products, but rather services provided by the firms that deal with clients (banks, investment dealers and counsellors). Under the CRM2 guidelines, clients must be shown what they paid in trading commissions, administration and advice charges, and mutual fund trailers. Product costs – management fees on ETFs, mutual funds and other types of funds – will not be included in the calculation.
So while the growth of ETFs is likely to accelerate, it won’t be because their use reduces the cost number on account statements. Rather, sales will increase because the alternative, mutual funds, no longer enables advisers to obscure their fees.
This is perhaps a cynical view, but consider the facts. The penetration of ETFs in Canada has been disappointing so far. Even though these simple, low-cost funds were conceived in Toronto 40 years ago, the percentage of assets held in ETFs lags far behind that in the United States. ETFs now total more than $2-trillion (U.S.) in the United States, while we’ve just passed the $100-billion (Canadian) mark. The major reason – ETFs don’t pay trailer commissions.
It’s not all bad for mutual funds
For the lowly mutual fund, all is not lost. There are some positives that come out of CRM2 and the possible elimination of trailer fees (the CSA has indicated they’re leaning that way).
It’s not often discussed, but trailer fees make performance comparisons between mutual funds and ETFs grossly unfair. It’s like comparing a Chevy loaded with options with a basic Ford. To be specific, the often-quoted SPIVA survey compares mutual funds with all fees included (including advice) to indexes that have no fees or trading costs factored in.
So while mutual fund companies are fighting tooth and nail against regulatory change, including the trailer ban, their antiquated compensation system invites unfair comparisons and sullies their reputation.
Indeed, firms that have kept their fees down and avoided using trailer fees have provided excellent long-term returns. I’m referring to Mawer Investment Management, PH&N Investor Services (owned by Royal Bank of Canada), Leith Wheeler Investment Counsel, Pembroke Private Wealth Management and our firm, Steadyhand Investment Funds. These investment managers deal directly with clients and use mutual funds to build portfolios for them.
I don’t know exactly how CRM2 will reshape the industry, but I do know it will put client-adviser relationships on a better footing. Fees will be more transparent, performance comparisons more meaningful and sales practices better aligned with clients’ best interests.