Jan 24, 2014 Just Wondering About How Compliance People Interpret New Forms

by John Degoey

Just Wondering About How Compliance People Interpret New Forms


So the next phase of the Client Relationship Model (CRM) is moving forward and most IIROC firms have new forms for when clients open (or update) their accounts.  The idea behind the forms and the information they capture wasthat there would be greater clarity regarding the primary purpose of the account(s) as well as better depictions of investment objectives and tolerance for risk.  Although I don’t know for sure, I think this might end up being a case of regulators needing to be careful what they wish (ask) for.

The first time this concern came to me was when my firm’s senior compliance officer pointed out that, in his opinion, having bonds (or bond funds. ETFs) with a maturity profile that extends beyond the investor’s time horizon, that mismatch might be a form of risk.  Specifically, the investor might need to sell prior to maturity and, owing to a possible rise in interest rates, might not get her principal back in the process.  Accordingly, long bonds with a short to medium time horizon ought to be coded as medium (not low) risk investment.  Fair enough.  For the record, I agree.  But let’s take the logic a bit further, shall we?

What if an investor buys a mutual fund with an associated deferred sales charge (DSC)?  Since DSCs generally take about 7 years to wind down to $0, it seems to me that if the time horizon for the purchase was less than 7 years (buying a house in 2017, for instance), then the risk would also be modified.  Is it?

Here’s where I think the rubber really hits the road: mutual fund turnover.  Many actively managed funds have a turnover of over 100%.  That means that if you held the underlying stocks in the fund, you would have sold every security in the fund and used the proceeds to buy a new security within one calendar year.  As an example, if you have $1,000,000 in a fund and wanted to replicate the positions individually, you might end up with (say) 40 stocks with about $25,000 invested in each stock.  Let’s compare the two options, shall we?

The mutual fund investor is a ‘buy and hold’ investor.  She simply buys her fund, checks on the performance from time to time, and takes a generally passive approach to owning it.  As far as she is concerned, she has no intention of engaging in active trading strategies and would never do such a thing if she was ‘running her own money’.  Unfortunately for her, the manager of the fund she purchased takes a rather different view and trades like a madman over the course of that year.  Note that the risk here (in terms of taxable capital gains) is particularly acute if the investor buys the fund in a taxable (i.e. non-registered account).

The mutual fund investor’s twin sister is an active, do-it-yourself (DIY) trader.  She buys the exact same 40 securities in the exact same proportion and, as fate would have it, makes sells and buys throughout the year that just happen to correspond with the sells and buys made by the manager that her sister has hired to manage the fund for her.

From a time horizon perspective, the difference is huge.  The first sister is (allegedly) taking a long-term, patient approach to how the portfolio is to be handled.  Her DIY sister, in contrast (note the irony) has made a series (40 to be exact) of decisions where the holding period for any given security in the portfolio was less than 365 days.

My question is simple… Do compliance departments look at the portfolio turnover of mutual funds when assessing an investor’s time horizon?  Consistency and logic suggest (and it seems to me that) they ought to.  After all, if they’re prepared to consider duration risk for bond positions, then a similar degree of logic ought to apply for turnover regarding equity positions. 


John De Goey, CFP,

Fellow of FPSC is a Vice President and Associate Portfolio Manager at Burgeonvest Bick Securities Limited (BBSL).  The views expressed are not necessarily shared by BBSL. John.degoey@bb

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