Trailing commissions are under review as the Canadian Securities Administrators (CSA) prepare to regulate mutual fund compensation. A study released in June put the spotlight on this method of remuneration, and now a second study published in October has concluded that commissions can have an adverse effect on fund performance, especially when they are too high.
In June, the Brondesbury Group’s report stressed how important it was that new compensation methods be developed for mutual funds. The researchers recognized, however, that they did not have the kind of data that would have enabled them to compare the performance of mutual funds with built-in commissions to those designed for fee-based accounts. Researchers at York University have now collected this information, and in October they published a 103 page scholarly study in which trailing commissions and deferred sales charges come off rather badly.
Douglas Cumming holds the Ontario Research Chair at the Schulich School of Business at York University. He and his co-authors Sofia Johan and Yelin Zhang relied on an unprecedented amount of comparative data when they put together the study, A Dissection of Mutual Fund Fees, Flows and Performance. Their analysis shows that advisors who are paid by commission tend to recommend a mutual fund regardless of how it has performed in the past. This sort of inclination can have a negative effect on the future performance of a client’s investments.
The CSA notes that Professor Cumming’s research builds on the literature review conducted by the Brondesbury Group earlier this year. “Both studies and the comments received during the previous consultation period are intended to be among the inputs that will be factored into the CSA’s determination of whether to effect certain policy changes,” explains CSA chairman Louis Morisset, who is also president and CEO of Quebec regulator, the Autorité des marchés financiers.
The CSA, however, are keeping their distance from the findings. “We remind readers that the views and opinions expressed in the enclosed report are those of the authors,” they write in bold face on the first page of the report. They plan to publish guidelines on how mutual fund commissions should be regulated in the first quarter of 2016.
The York University researchers based their findings on data obtained directly from mutual fund managers in Canada. The sample comprises 43 of the 113 fund families that were available in the Canadian marketplace at the end of 2014.
According to Investor Economics, this data represents 66.7% of assets held in individual mutual funds out of an estimated total of $1.1 billion. The sample used by researchers also counts for 48.6% of assets under management in funds of funds, or $152 billion of an estimated total of $295 billion. The sample includes 22,077 of the fund codes registered on the FundSERV transaction system.
Researchers divided the data into four groups, depending on whether the information came from funds of funds or individual funds, and if funds could or could not be purchased directly from the manufacturer. They also analysed the funds according to their fee structure: no load funds without sales charges (and with built-in trailing commissions); those with deferred sales charges; those with negotiable front-end loads (and with built-in trailing omissions); and fee-based funds.
The comparison favours fee-based funds over those that pay trailing commissions, and argues that the fee model encourages advisors to recommend funds that stand out from the crowd based on how they have performed previously. Trailing commissions, on the other hand, encouraged advisors to recommend funds irrespective of their past performance. Researchers define performance as “alpha”, which is a measure based on whether the performance of a fund has been higher or lower than that of its benchmark for a given period. Several manufacturers define it as risk-adjusted returns.
Fund inflows (net sales) do not lie. In general, Cumming’s research team found that the best performing funds were best able to gather assets. For example, the study found that the funds which ranked in the top quartile in terms of performance gained 0.21% more assets in the following month, while the funds in the last quartile lost 0.02% of their assets the next month.
However, this relationship between good performance and an increase in assets tends to be weaker for funds that pay trailing commissions. The researchers note that assets continued to flow into funds that paid trailers, even when their past performance was poor. They found that the same was true of funds with a deferred sales charge and of funds which are sold by a dealer that is affiliated with the fund manufacturer.
Funds that pay 1.5% trailing commissions (considered to be among the highest) saw their assets under management increase by 0.3% each month, with their stream of monthly sales flowing in each month regardless of past performance.
According to the report, if the performance of a fund that pays trailing commissions deteriorates, it will still gather 15% more inflows than a fund that does not pay commissions. The opposite is also true; if performance of a fund that pays trailing commissions declines, the net capital outflows are 15% less than in funds that do not pay a trailer fee.
The data indicate that an increase in commissions results in decreased performance, while on the other hand a decrease in commissions tends to lead to an increase in performance.
A fee-based fund behaves quite differently. If its performance falls from the first quartile to the last, it will see its inflows drop off by 0.32%, notes the report. As for comparable funds that pay commissions, their inflows will only drop by 0.19%.
The report goes on to suggest that commissions may result in a conflict of interest. “One potential conflict of interest in mutual fund compensation structures is that investment advisors may have incentives to recommend products to investors for reasons that are not strictly based on the expected risk-adjusted performance (‘alpha’) of the investment,” say the authors. “This conflict may arise when fees compensate advisors and managers regardless of performance.”
The financial advisors association Advocis was the first to respond publicly to the report, and it expressed reservations about its conclusions. “Any decisions in regard to product sales or offerings in the marketplace must ensure that advice is broadened, not restricted,” says Advocis CEO Greg Pollock.
He adds that the report seems to ignore the monetary value of financial advice given to clients. “Our anecdotal evidence tells us that Canadians are generally satisfied with the current commission system for mutual funds. There’s a cost associated with advice regardless of how it is paid. Not every Canadian can afford to pay an upfront fee for service, which can be several hundred dollars an hour,” comments Pollock.
Invesco Canada has also publicly reacted to the York University study. Far from seeing it as a threat to trailing commissions, Invesco CEO Peter Intraligi welcomed the report, which is in line with some of his own beliefs.
Intraligi denounced the practice of paying excessively high commissions after the Brondesbury report was published. He is pleased that the Cumming report has raised the issue once again. “Higher trailing commissions can influence sales flows,” observes Intraligi in a letter responding to the study, a copy of which was obtained by The Insurance and Investment Journal.
In a subsequent interview with the magazine, Intraligi pointed out that most industry players have capped their trailing commissions at 1% for equity funds and 0.50% for bond funds. “If you cap equity funds at 1% and fixed income funds at 0.5%, you essentially eliminate potential for conflict of interests. The only thing that differentiates funds then is performance,” he says.
Intraligi has noticed that some manufacturers have overstepped this norm in recent years, increasing their trailing commissions to 1.25% or 1.50%. He notes that Professor Cumming’s study shows these funds garnered sales that were surprisingly high compared to their performance.
Given the results of the study, it would appear that manufacturers whose funds are performing poorly try to increase their sales by offering larger trailing commissions, suggests Intraligi.
He is, however, opposed to doing away with commissions altogether and invites the CSA to consider other avenues, such as establishing a regulatory maximum of 1% on trailing commissions. He believes further research is required, and says he would welcome a detailed sensitivity analysis on the impact of excessive trailing commissions.
The Cumming Report confirms another one of Invesco’s convictions, namely that past performance plays a lesser role when funds sold by advisors who are affiliated with the manufacturer. “Performance drives sales among independent fund companies, but not necessarily among affiliated fund companies,” writes Intraligi.
In an interview with The Insurance and Investment Journal Don Reed, the CEO of Franklin Templeton Investments, said there is a fair amount of common sense in the Cumming report. “The key factor in individual funds is, for the most part, performance. That’s not surprising. We see this all the time,” says Reed. “The best performing funds are those that always have the best sales, because people look at performance. They assume the track record will continue.”
There is also no surprise about fee-based funds. The study reveals that they generate more sales when they perform well. “The fee-based client is probably a little bit more sensitive to things like performance, because he is writing a cheque to his advisor. He pays the fee directly. It is separated as opposed to being part of the overall fees,” explains Reed. For this reason, he says this type of client expects his advisor to generate higher returns.
He notes that fee-based asset management has the wind in its sails at the moment, and points out that about 70% of advisors in the United States have adopted the fee-based compensation model. “In Canada, that number would be lower, but it is growing,” he says.
He agrees with the Cumming report as far as high commissions are concerned. A higher than normal trailing commission may have an influence on the relationship between sales and past performance. In Reed’s opinion, the standard level of commission in the industry is about 1%.
However, Reed does have reservations about the conclusions the researchers have drawn from this large collection of statistics. He suggests they should examine things at a deeper level in order to obtain more solid conclusions; several other, less scientific, factors may be involved and could help to explain why sales continue to flow into a fund despite its poor performance.
Two investors are having a conversation. One says he has purchased a security that is increasing but paying low dividends. Another says he has invested in a security whose value is not rising as quickly but which is paying higher dividends. Which one is assuming a greater investment risk? asks Reed. In his opinion, each of these two investors will have a different view of the risk they are assuming, since one is primarily seeking growth while the other is happy to receive high dividends regardless of capital gains. “You have to consider the individual psyche as opposed to mass data,” says Reed.
Despite the major findings of this latest report, Reed is not worried about the future of commissions, which exist for a reason. “Trailing commissions are designed to reward the advisor for the service he provides to the client,” says Reed. He believes that the second phase of the Client Relationship Model regulations (CRM2) will bring the subject to the front and centre. “CRM2 is going to be showing all the breakdown of the costs that the client is paying. They could find it out another way. But CRM2 will make it more evident to a lot of people that don’t always look at things like the financial statements,” he says.
On the other side of the spectrum, the investor protection organisation FAIR Canada would like to see trailing commissions disappear. It has been campaigning to abolish them for quite some time. The organisation reacted positively to the conclusions of the Cumming report but interprets them differently than the fund manufacturers. “The report shows that trailing commissions do have an impact on investment in mutual funds, and it’s an impact that harms investors,” says FAIR in a bulletin published in October.
FAIR highlights the fact that past performance has less of an influence on fund sales when manufacturers pay trailing commissions. “That’s a bad thing for investors because it indicates something other than what’s best for the investor is driving sales,” reads the document.
The advocacy group also points out that the report found a correspondence between an increase in trailers and a decrease in performance. “The data indicate that 2.5% of funds permanently increased their trailer fees....[and for those funds] alpha [risk adjusted performance] dropped by 32.4% on average,” quotes FAIR Canada, which says that allowing any factor but performance to encourage investment in a fund makes it less imperative for fund managers to perform well.