Problems with trailer fees highlighted by new study

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Mutual funds that pay trailer fees to financial advisers attract higher inflows of cash from investors even when they perform badly and tend to perform worse over all than other funds, according to critical new research commissioned by Canada's securities regulators.

The fund review, led by York University finance professor Douglas Cumming, has been keenly anticipated by regulators who are gathering evidence to help decide whether to change the fee model for mutual fund sales in Canada and possibly even ban the use of trailer fees, which has already happened in Britain and Australia.

The study, commissioned by provincial securities commissions across Canada, suggests advisers recommending mutual funds to clients are clearly motivated by the presence of trailer fees, which are fees paid to advisers annually as long as a client holds the mutual fund.

Many clients are unaware their advisers receive trailer fees from some mutual fund companies, which serve as an inducement to recommend certain funds.

In an interview Thursday, Prof. Cumming said the reports' findings are important because people can have their investment decisions "distorted" if investment advisers are paid more by recommending funds that pay them trailer fees.

He said he knows the report's findings will be unpopular in the mutual fund sector and colleagues have joked he should change his address. But he said the data speak clearly, demonstrating trailer fee payments have a significant impact on investment flows.

"Does it make the mutual fund industry look bad? Yes it does. Is it my fault? No, I'm just the data guy," he said.

The Investment Funds Institute of Canada, the industry association for Canada's mutual fund companies, said Thursday that it is still reviewing the report and chief executive officer Joanne De Laurentiis was not available to comment.

Monica Kowal, vice-chair of the Ontario Securities Commission, said the research "really validates" the concerns that led regulators to launch the review of mutual fund fees in 2012. She said regulators wanted independent and rigorous research before developing any changes.

Ms. Kowal said regulators expect to report in the first half of next year on what they will do about mutual fund fee reforms.

According to the study, the presence of trailer fees increases net flows of money into a mutual fund regardless of its past performance. And the greater the trailer fee, the more money that flows into the fund without any relationship to past performance.

For example, the report said a trailer fee of 1.5 per cent increases the average monthly inflow of investors' funds by 0.3 per cent of assets under management each month, regardless of the fund's past performance.

Conversely, fee-based mutual funds that do not pay trailer fees are far more sensitive to performance, which means investors typically buy more of those funds when they are performing well and less when the funds are doing poorly.

A fund that moves from top quartile to bottom quartile performance, for example, has a drop in investment flow of 0.32 per cent in the subsequent month under a fee-based purchase option, but a far less decline under other fee formats that involve trailer fee payments. No-load funds, which do no charge front-end commissions but do pay trailer fees, have a 0.19-per-cent drop in average investment flow the subsequent month when a fund moves from top quartile to bottom quartile performance, the report shows.

Moreover, the report also finds that mutual funds that pay higher trailer fees have a far worse performance over all than those that don't pay trailer fees.

Funds that permanently increased their trailer fees during the sample period from 2003 to 2014 saw performance drop 32.4 per cent on average over a period spanning six months before the change to 24 months afterward. Funds that decreased their trailer fees showed an 88-per-cent improvement over the same period.

The study also found that funds typically sold through dealers affiliated with the mutual fund company also perform worse than those primarily sold by independent advisers.

Prof. Cumming said fund managers may be aware their funds will continue to have new inflows of cash when there are high trailer fees so have less motivation to perform well to ensure clients remain invested.

He said his report does not draw conclusions about what regulators should do next because he was asked only to study mutual fund data.

"It's not my job to tell them to go ban trailer fees, but the data say a very clear picture about what's going on in the industry," he said.

Robert Sedran, financial services industry analyst at CIBC World Markets, issued a note Thursday saying the report's findings "are consistent with our conclusion that trailer fees will be phased out."

Atul Tiwari, managing director of Vanguard Investments Canada Inc., said Prof. Cumming's research supports his firm's view that fee-based payments are a preferable model for the fund industry. His firm does not pay trailer fees to advisers, arguing the fee-based approach lowers costs for investors and improves returns.

Mr. Tiwari said investment advisers in countries that have banned trailer fees have ended up expanding other services to clients, and have turned to more lower-cost exchange traded funds or index funds for their clients.