A research project conducted by Investor Economics (IE) on behalf of The Investment Funds Institute of Canada (IFIC) considered whether compensation methods can influence fund flows and advisor behaviour.
The IE study, Analysis of Factors Influencing Sales, Retention and Redemptions of Mutual Fund Units, was conducted in September and released in late February. The 83-page report is a wide-ranging analysis of the Canadian mutual fund industry and considers the influences behind sales and redemptions, how investors and advisors choose specific funds, and the role that compensation plays.
Three significant influences
The paper concludes that there is no single factor that can satisfactorily explain the volume of sales and redemptions of a mutual fund at a given point of time. Instead, IE believes that there are three significant influences at play: macroeconomic and demographic factors, individual fund returns, and preferred access to distribution.
IE says that macro-economics and demographics have the potential to overpower all other factors, making certain mutual funds and asset classes more attractive than others. “The old mutual fund industry adage states that it is not possible to ‘sell against’ specific investor asset class preferences. As documented in this report, there is plentiful, fact-based evidence that this axiom still pertains,” reads the report.
As for individual investment return characteristics, the paper argues that they are the single most valuable predictor of sales and redemptions at the individual fund level. While a high performing fund cannot reverse the macro-economic tides, IE says good returns can boost fund sales, improve retention experience, and help to gain the attention of advisors.
Although companies that have preferred access to distribution through a captive or affiliated sales force may benefit from heightened flow activity to their funds, IE says that distribution alone is no guarantee of positive sales experience. It is the macroeconomic environment and solid investment performance that form the basis of the relationship between advisors and clients. “When those factors are in place, however, our research found that fund companies with access to affiliated distributors have experienced, in aggregate, a consistently higher level of net flows than those without access to affiliated distribution,” concludes the paper.
Choice of investment products
The IE report points out that advisors at full service brokerages still rely heavily on mutual funds even though they have access to other investment products such as individual securities and exchange-traded funds (ETFs). For financial advisors regulated by the Investment Industry Regulatory Organization of Canada (IIROC), IE found that the asset mix breaks down to 3.2% in deposits, 69.8% in mutual funds, 7.6% in segregated funds, 17.7% in equities and ETFs, and 1.8% in other investments. For those in the Mutual Fund Dealers Association (MFDA) channel, 1.7% of assets are held in deposits, 93.1% in mutual funds, 4.7% in segregated funds, and 0.5% in other investments.
In terms of advisor compensation, IE says that the statistical relationship between trailer levels and net flow volumes is not significant. Instead, the paper argues that advisors and clients assign more importance to a fund’s investment returns than they do to the compensation it pays.
For advisors with smaller books of business, IE notes that deferred sales charge remains the most popular form of remuneration. This is due mostly to the fact that fee-based platforms are “uneconomical” for dealers operating in the client’s name. However, the paper does reveal a shift towards unbundled fee-based advice in all channels.
In the full-service brokerage business, 35% of assets are now in fee-based programs, up from 19% seven years earlier. In the financial advisor channel (i.e., among mutual-fund and insurance-licensed advisors operating outside of the banks), the transition to fee-based compensation has been slower but it is still present. Funds in this network are largely held in non-discretionary fee-based programs and they only accounted for 3.3% of total assets at the end of December 2014. However, by December 2024, IE forecasts that fee-based programs will hold 28% of assets in the financial advisor channel.
“The opening of the mutual fund dealer shelf to ETFs via a broader, industry-level solution could arguably provide additional incentive for the move to an unbundled fee- based practice there, as well. Product shelf and a clear difference in how the cost of advice is applied, such as via transaction-based versus fee-based, appears to be a key catalyst for advisors to shift to an unbundled, fee-based practice,” comments IE. “With changes potentially coming in ETF operational barriers, it will be interesting to see what will emerge on the unbundled fee-based stage.”
The IE/IFIC report is not without its critics. Professor Douglas Cumming, Sofia Johan, and Yelin Zhang from the Schulich School of Business at York University, who conducted their own research paper on the influence of fund fees at the behest of the Canadian Securities Administrators (CSA), reviewed IE’s research and believe that it is seriously flawed. Their conclusions were released by the CSA in early February.
Among other things, Cumming and his colleagues take issue with the fact that IE’s paper presents simple correlations and simple ordinary least squares (OLS) on a panel dataset.
“Simple correlations do not establish causality on anything conclusive about the relationship between variables because they do not control for other things being equal,” argue Cumming and his associates. As for simple OLS on panel data, the team from York University say that it is well established that this method is “statistically wrong” because it assumes all funds have exactly the same characteristics. Furthermore, they say the IE study lacked information at the FundSERV code level and failed to account for risk adjusted fund performance (i.e., alpha).
“In summary, the Investor Economics report studies the wrong measure of returns with insufficiently detailed data, and completely incorrect econometric methods that ignores over half a century of econometrics and statistics, and has qualitative arguments that only serve to highlight the mistakes with the econometric methods used,” concludes the response from Cumming, Johan, and Zhang. “Without the necessary econometric underpinnings and data, Investor Economics can say absolutely nothing about the relationship between mutual fund performance and mutual fund flows or about other pertinent factors that may affect those flows.”
The Insurance and Investment Journal contacted Investor Economics for their response to Cumming’s criticisms when they were first published in February, but the firm did not respond to our query.