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Sep 1, 2016

Slow Progress Better Than No Progress

by John DeGoey

John De GoeyGlorianne Stromberg wrote her initial report on mutual funds - recommending the end of trailing commissions - in 1995. A full generation later, we’re still waiting for that to happen. Meanwhile, many other nations have passed Canada in terms of promoting transparency, removing conflicts of interest and ultimately protecting the primacy of investor interests. Achingly and ever so slowly, Canada is being dragged kicking and screaming into the 21st century, where securities regulation systematically weeds out the sales element of the industry that has dominated the cultural mindset since it was established.

When talking about the Canadian Securities Administrators (CSA) – the combined Provincial and Territorial Securities Commissions – it is useful to remember that when all is said and done, more has been said than done. There have been copious reports, white papers and studies. There have been long-standing comment periods and feedback loops leading to (so we are told) arduous negotiations between the disparate provinces where standards are usually watered down, but ultimately (so we are told) approved. It now looks as though 2016 will finally be the year where we begin to see some tangible action.  

First on the docket is the so-called “CRM II” – the second phase of the Client Relationship Model. In fairness, the first phase of CRM was enacted a few years ago, but it dealt with relatively mundane matters like the disclosure of potential conflicts at the firm level and the use of “trigger events” (transfers in, new representative, etc.) that might cause suitability reviews. In addition, CRM I led to a few relatively modest re-evaluations of the risk and suitability profile of certain products. For instance, long term bonds – even those issued by the government of Canada – have since been deemed to be medium risk owing to the potential loss of capital (no matter how small the loss or how remote the possibility) on New Client Application Forms (NCAFs). My layman’s sense is that this does more to protect advisory firms than it does to protect the public, but I digress.

As of July 15, 2016, CRM II will be the new sheriff in town when it comes to reporting for retail clients. There are two major changes that retail clients will likely come to think of as a major sea change in account reporting. The two forthcoming changes are:

      I.         total compensation paid to the advisory firm; and

    II.         consistent, mandatory performance reporting

As a practical matter, many reports will not actually contain this information until early 2017, however. Still, there are many who believe this new regime of reporting will cause clients to stand up and take notice like never before. Many – perhaps even most – clients will likely be shocked at how much they have been paying and at how poorly they have been performing. The linkage between those two realities is one that much of the industry has continually tried to deny.   Cost and performance have been shown to correlate negatively. The reason is simple -in the immortal words of John Bogle: “You get what you don’t pay for”. Stated even more plainly and in very general terms, the more products cost, the worse they tend to perform – over the long run and on average.  

The matter of compensation is a simple enough one to explain for anyone who has taken the time to engage in meaningful client disclosure. Like pretty much anything in life, financial advice is not free. Still, numerous studies have shown that a large portion of retail clients have absolutely no idea of how – or how much – their advisors are being paid. Truth be told, many may still not understand the ‘how’ part when it comes to embedded compensation (i.e. trailing commissions). The ‘how much’ part, however, will soon be spelled out for them in black and white on every statement they receive. The veil is about to be lifted.

The obvious gap in this reporting is that it only talks about how much investors are paying for advice; it does nothing to offer similar disclosures in regard to product cost…. as if a person would renovate their house and only be interested in how much the contractor charges for his labour without any regard to how much the materials, fixtures and appliances might also cost. Clients are paying for both. They should be told with equal certitude how much things cost. One of the problems we have in Canada is that product costs are notoriously high. Not spelling out the cost of products allows advisors to continue to use high-cost products as though cost wasn’t a material consideration. It is, in my view, a major shortcoming.

Performance reporting may well be an even bigger issue down the road. I can’t begin to tell you how many advisors are still telling their clients that it would be reasonable to expect long term returns in the high single-digit range for a balanced portfolio. Notwithstanding the recent weakness in capital market performance (a severe drag on optics to begin with), most experts feel long term expectations for a diversified portfolio might be in the mid-single digit range – especially if inflation remains low (real returns are relatively constant).  

There’s more to come. There has been talk of even more ‘direction’ (not always synonymous with actual legislation) with regarding commissions – especially deferred sales charges, as well as for fiduciary obligations (aka a Statutory Best Interest Duty) and, in some circles, the formal regulation of financial advisors in general and financial planners in particular. I’ll write about these purported forthcoming developments as news breaks throughout 2016.  

The bad news is that real change has taken at least a generation to be implemented (the clock is still ticking, after all). The good news is that we finally seem to be poised to see some tangible results. Watch this space to see what transpires.

John J. De Goey, CFP, CIM, FELLOW OF FPSC is a Portfolio Manager with iA Securities. The views expressed are not necessarily shared by iA Securities.