By Scott Ronalds
There’s an old saying that mutual funds are sold, not bought. Canada’s mutual fund industry is a perfect example.
The majority of financial advisors are paid commissions by fund companies for selling their funds and keeping clients invested in them. Up-front commissions can run as high as 5% or more, while trailing commissions (paid each year) typically range from 0.5% for bond funds to 1.0% for equity funds. In other words, an advisor who sells a client $100,000 worth of XYZ Fund may receive $5,000 up-front and $1,000 each year (give or take, based on market fluctuations) from the fund company for keeping the client invested in the fund. The commissions are paid to the advisor for advice they provide to the investor.
Critics of this structure argue that it has two big flaws. First, advisors may be enticed or biased toward selling products that pay the highest commissions, thereby ignoring the best interests of their clients. Second, the transparency is awful. Investors are often unaware of the fees they pay and how much their advisor is compensated for selling them a fund and providing ongoing advice.
The U.K., which has a similar compensation structure for advisors, recently took the bold step of banning commissions on financial products. The country’s Financial Services Authority (FSA) recently announced that by the end of 2012 advisors will no longer be allowed to receive commissions on products they sell to investors. Instead, investors will be charged separately for advice.
The FSA noted: “Firms will have to be upfront about how much they charge for their services, and no longer hide the cost of their advice behind the cost of a product…consumers will know what they are buying up-front, how much it will cost them and also have the peace of mind that it was recommended to suit their needs.”
Regulators in Australia are considering a similar course of action, where it is being recommended that up-front commissions and trailing commissions should not be permitted in relation to personal advice.
Such moves would go far in improving transparency. Investors would be equipped with a better idea of the all-in cost of buying and holding a financial product. What a concept. Maybe it will make its way to Canada. Or is that just crazy talk?