Coming to demystify financial advisor compensation: CRM2

Effective July 15, 2016, new disclosure requirements will shed light on fees and performance through a regulatory initiative known as Client Relationship Model, phase 2 – or CRM2. CRM2 is an effort by the Canadian Securities Administrators to provide better disclosure and clarify how financial advisors are compensated.

The goal is to provide more transparency to Canadian investors on how their advisors are being compensated for managing their money. Up until now it has been a big black box. Rob and Marie Engen of the Boomer and Echo blog eloquently outlined how Canadians have been wandering nomads when it comes to understanding the costs of investing in Canada, specifically:

  • Canadians pay the highest mutual fund fees in the world – costs that are hidden and rolled up into a percentage that many investors simply don’t understand.
  • The average investor spends just an hour or two a year with their advisor and is unaware that an advisor is not required to act in their best interest.
  • Investors don’t hear about lower cost funds, index funds, or ETFs,
  • nor have they ever received an account statement that shows how their portfolio was doing – an annual rate of return that’s compared against an appropriate benchmark.
  • They don’t even know how their advisor is paid.

What should happen with CRM2?

CRM2 is an attempt to open the hood for investors to gain better insight on how the financial services apparatchik operates and to determine how effectively their advisor is working for them.

According to John Adams, the second vice-chair of the Investment Funds Institute of Canada (IFIC) and CEO of PFSL Investments Canada  “What there will be is a better discussion between advisors and their clients as to the value that advisors and the value that mutual funds bring to investors and a bit more of a discussion about the alternatives.”

What could happen

John DeGoey, associate portfolio manager at Burgeonvest Bick Securities Ltd. in Toronto believes that “The real poop hitting the fan will be two years from today on July 15, 2016 when there will be mandatory full disclosure of product costs and advisory costs. That in my opinion will be transformational,” he says. “I wouldn’t be surprised if more than one quarter of clients were sufficiently disturbed by what they see that they will be inclined to move their accounts. I think 25% will pick up their marbles and go somewhere else — some of them will switch advisors and some will become do-it-yourselfers.”

There should be some hurt feelings by investors and difficult conversations coming for advisors. The good one’s will be ready and will have a scripted response to the likely questions.  The good advisors will probably have implemented most of these CRM2 requirements already.

In Australia, a new regulatory mandate called the Future of Financial Advice (FOFA) highlighted investment fees and led to investors moving toward lower cost products. After the implementation of FOFA, the use of ETFs almost doubled, according to June, 2014, data provided by the Australia Stock Exchange. Over an 18-month span assets rose to $11.9-billion (Canadian) from $6.54-billion.

In 2012, Britain implemented the Retail Distribution Review, a regulatory change that affected how investors were paying for financial advice. In a recent review by the Financial Conduct Authority, Britain’s financial industry regulator, it stated there has been a noticeable decline in the sales of higher commission financial products.

What is more likely to happen

As Canadians, we just don’t seem willing en masse to move with our wallets. We’re happy to stay with our family doctor, our local bank or financial advisor because it’s a comfort thing. They may have been recommended by a family member or close friend. How many times have you heard a colleague say, “my portfolio has been underwhelming, but my financial advisor is a really nice person.”  I think many people just don’t want to have that difficult conversation.  

I think when this conversation occurs that many people will have a hard time breaking up especially if the cost benefit is only marginal.

Investor reaction to fee disclosure may depend on how the market is performing, says Peter Hodson, founder and CEO of 5i Research Inc. “Most people don’t care if they’re making 15% or 20% in the market but once that drops down to 6 or 7% and once they find out that the mutual fund company is making 2 or 3%, then suddenly, that becomes much more in focus.”

These directives apply to mutual funds which in Canada are still the highest selling and are the most adoptive asset investment security product used. Almost a $1-trillion is held in mutual fund assets as of the end of 2013. Some 117 mutual fund companies offer almost 3,000 funds. From what I can surmise CRM2 doesn’t apply  to other investment products like ETF’s, index funds, and simple individual stocks and bonds.  The industry knows this and I really doubt they will stand by and go along in full form. I expect some rebranding of product. We’re already seeing this with the greater proliferation of ETF products that utilize active management strategies. The traditional Canadian mutual fund companies haven’t embraced it yet (why bother if you have an inert, captive client base?) but I can eventually see them morphing their funds into an ETF structure, mainly because their commission based sales force will demand it. Traditionally ETF’s were passive products that mirrored or tracked a specific broad market index like the S&P 500 or TSX/S&P Composite.  It wouldn’t surprise me to see some advisors shun the traditional mutual fund for the more efficient, real-time, tradeable, actively managed ETF model.  So instead of charging a 3 percent load, they’ll charge 1%. It’s a welcome discount from the investor perspective. At the end of the day, I’m sure the advisor could make a pretty decent living at that rate.

Changing Teams:

In anticipation of CRM2, some advisors have decided to bail and hang up a different shingle.  There is a slow growing movement of advisors giving up their investment licenses and selling insurance products instead. Firms and individuals licensed to sell insurance are regulated by provincial insurance regulators (e.g., Financial Services Commission of Ontario or FSCO) but are out of reach of provincial securities regulators. There appear to be a increasing number of advisors willing to do this to escape the reporting of performance and costs. According to Dan Hallett of HighView Financial Group, “insurance advisors will be Teflon as far as CRM2 is concerned.”

Churning ahead of CRM2 implementation

Mr. Hallett has also observes that,

“In a similar effort to minimize the impact of CRM2’s cost reporting component, many advisers are initiating dubiously-clever transactions. CRM2’s cost report will show a list of amounts charged directly to clients and commissions received on behalf of the client’s investments. But this only starts after mid-July 2016 – which means that the first report won’t be issued to clients until 2017.”

“In the meantime, I’m told by a variety of sources that many advisers are pushing through what’s been described to me as “a boatload” of mutual fund sales under a deferred sales charge (DSC) option. When an adviser sells a mutual fund on a front-end load (FEL) basis, she generally receives no up-front commission payment and an ongoing trailing commission of 0.5 per cent to 1 per cent per year based on the value of the investment. (Commissions are paid to the dealer, of which 25 per cent to 100 per cent is paid to the individual adviser).”

“Clients investing in a DSC fund trigger a bigger up-front commission – i.e. usually 4 per cent to 5 per cent of the value of the investment – plus a trailing commission of 0.25 per cent to 0.50 per cent per year. So advisers who are able to sell a pile of DSC funds will be paid significant up-front commissions prior to 2016 – which won’t show up on any cost and commission report because it’s not currently required.”

Invisible Hand to Fee-Based Compensation

The logical evolution would likely be that advisors would be compelled to adopt a fee-only service model which would seem like a rational progression, however as Mr. Hallett comments, “… the problem is that many fee-based advisers won’t deal with clients who don’t have at least $500,000 in investable assets. Earning $1,000 from a client annually, or 1 per cent of $100,000 worth of investable assets, just isn’t worth their time. If you ban commissions, as Britain has done, it could leave many Canadians hung out to dry – even those with sizable portfolios worth $100,000 to $200,000.” Many experts proclaim that the emergence of Robo Advisors that offer automated portfolio management services people with lower asset bases will fill that gap, however these services are very new and there is no real performance history behind these services.

Branding of Transparency: The ISO model

If you remember in the mid 90’s and 2000’s the big rage in business was displaying the ISO sign in your logo or your business cards. The ISO 9000 and family of certifications represented conformity with a global umbrella of quality management systems standards that were designed  to help organizations ensure that they met the needs of customers and other stakeholders while meeting statutory and regulatory requirements related to a product. It wouldn’t surprise me if CRM2 ushers an ISO like era of branding by financial advisory companies, that signals to investors that they espouse to higher level of cost and performance transparency.

The thing about these ISO companies was even though they adhered to a standardized process documentation model, that doesn’t make them a better more successful company. What is projected to the outside world is not necessarily what is being practiced internally. It’s basically marketing.

At first blush, CRM2 would seem to be a boon for investors. Having more clarity in terms of how one’s investing dollars are being managed can never be a bad thing. I just have a hard time seeing the financial services industry just willingly going along and implementing this in the full spirit it is being intended for. As we speak, I suspect the sales departments are looking for ways to modify their product mix so that it muddies the waters enough in terms of what can be disclosed to its customers. The history is there and we are seeing some early evidence that the spinning is getting underway.