Big changes are in the regulatory winds and they’re going to be good for Canadians. The new rules that are coming down relating to cost disclosure, performance reporting and client statements are likely to have more impact on individual investors than anything we’ve seen in decades.
Friday was the last day for investors and industry players to express their views to the Canadian Securities Administrators on changes being made to National Instrument 31-103. With the comment period over, it’s expected the final amendments will be announced in early 2013. After a transition period of one to three years, registered dealers and advisers will be required to show clients what they’ve paid for investment services (in dollars and cents) and what their investment returns were. All types of commissions and fees will be accounted for, including the mystery area for all investors, the cost of trading bonds.
Throughout the consultation period, the trailing commissions that are paid to advisers and salespeople by mutual fund companies have generated the most comments. The industry has questioned whether the costs of disclosing the actual dollar amounts of these fees outweigh the benefits. The Investment Funds Institute of Canada (IFIC) and others have pointed out that trailers are already disclosed (in percentage terms) in the required point-of-sale documents.
The CSA’s response, however, has been unequivocal. “We do not agree. We acknowledge the potential costs to the industry, but believe that informing the investing public is worth this cost.”
The CSA is being so firm on the trailer issue because it’s done research that shows that investors don’t understand trailing commissions, even though they make up a significant part of a fund’s management expense ratio (MER).
An important thing to note here is that the CSA is not banning trailing commissions, as some other countries are. It’s going to make sure, however, that this form of dealer compensation is fully transparent.
There’s no doubt that improved reporting will be challenging and expensive to implement, but the fund companies and dealers deserve little sympathy. There have been plenty of opportunities over the last 20 years to bring more clarity to fees and returns, but they’ve dragged their feet and left it to the regulators to provide leadership.
For most firms, this project will cost a fraction of what’s spent on product development and marketing, and yet it will arguably do more to improve client returns. What are the benefits to clients knowing what they’re paying and how they’re doing? How about priceless?
It appears the CSA is also going to be prescriptive with regard to performance reporting. The revised proposal calls for firms to report dollar-weighted returns as opposed to the current industry standard, which is time-weighted returns. The time-weighted approach is not sensitive to contributions or withdrawals and is the cleanest measure of how a fund manager or adviser has performed. Dollar-weighted returns (also referred to as internal rate of return or IRR) take into account cash flows and are therefore more influenced by when a client puts money in or takes it out.
A simple example illustrates the difference. Let’s say Fred invests $10,000 and loses 20 per cent in the first year. He then takes advantage of the market weakness and invests another $100,000. His portfolio goes up 25 per cent and finishes year two with a market value of $135,000. Using the time-weighted method, Fred’s return is zero (down 20 per cent, followed by up 25 per cent, nets out to zero per cent). Using the dollar-weighted approach, however, the return is 20.4 per cent, a number that reflects the fact that Fred had more money at work on the way up and has earned $25,000 overall.
This issue makes my brain hurt. It will be tough to resolve because both methods have their merits. The industry would like to have the freedom to use either method, but the drawback to this is obvious. Comparing returns across providers with different methodologies will be like comparing apples to oranges.
When these much-needed changes are finalized in early 2013, I’m hoping to see some of the large firms in the industry take a leadership role.
By acting with urgency and committing serious resources to improving their reporting and disclosure, they’ll be doing more for their clients than they could with any educational seminar or brochure, Web enhancement or new product.