Mutual funds are as Canadian as hockey, doughnuts and snow. The big question is why

Mutual funds are as Canadian as hockey, doughnuts and snow. The big question is why

M. Corey Goldman | February 6, 2014 9:50 AM ET
This article appears in the February, 2014 edition of the Financial Post Magazine. Visit the iTunes store to download the iPad edition of this month’s issue.

The mutual fund is one of the more democratic inventions of the modern-era investment world: the pooling together of thousands of investors’ capital and placing it in the capable hands of an investment professional, generating collective returns and mitigating collective risk at a fraction of the cost it would otherwise be for investors to go it alone. Over the past 30-plus years, the fund has become the investing embodiment of millions of Canadians: It’s become the revered, must-have, do-no-wrong investment vehicle of choice for building a nest egg, saving for retirement and passing on savings to the next generation.

Financial advisors and banks flout them as the clear investment vehicle of choice — as necessary for your investment health as vitamins are for your body’s health. Mutual fund companies devote millions marketing them to anyone who might consider setting up a monthly contribution or, better, signs over a big chunk of his or her savings. They are as culturally entrenched as hockey, housing and snow and they continue to win the popularity contest, despite the proliferation of more economical — that is, cheaper — options such as exchange-traded funds and even low-cost mutual funds.

The question is: Why?

The rise of ETFs, which charge a fraction of what many mutual funds do, has certainly managed to scoop some money away from mutual funds, as have low-fee ‘do it yourself’ mutual funds that can either be purchased directly from a bank or mutual fund company without the intermediary of an advisor. Yet most cash still goes to the vast majority of old-fashioned, fee-charging mutual funds. As of Nov. 30, 2013, the most recent figures available, mutual fund assets under management in this country were $986.4 billion. By contrast, assets under management in the Canadian ETF space were $62 billion, a record, but a paltry fraction of the money sloshing around in mutual funds.

Advisors want to get paid, but don’t want to give their clients a bill, and mutual funds allow that, whereas ETFs don’t

Part of the reason is cultural. In a country where six main financial institutions serve most of the population’s banking and investment needs, the comfort, security and ability to walk into a branch and buy a mutual fund is, well, just the way it is. It is routine, like reordering cheques or renewing the mortgage. The bigger reason, however, is something many in the industry don’t want to talk about: Advisors make money when they put their clients in mutual fund products — and don’t make money when they put them into other investments. “The No. 1 reason, with a bullet, is embedded compensation — the trailing commission,” says John DeGoey, vice-president and associate portfolio manager at Toronto-based investment services firm BBSL, and author of Professional Financial Advisor III, a book about the business of giving financial advice. “Advisors want to get paid, but don’t want to give their clients a bill, and mutual funds allow that, whereas ETFs don’t.”

Mutual funds have a long history in Canada, starting with Canadian Investment Fund Ltd. (CIF), which opened for business in 1932, just three years after the 1929 market crash. But the industry didn’t really begin to take off until the 1960s, when relatively low interest rates and growing interest in getting back into the stock market had investors looking for non-cash investing alternatives. Even then, the influx wasn’t massive. It wasn’t until the early 1990s, when a combination of strong stock market gains and inventive ways to both market and “distribute” product — putting it in front of financial advisors and offering them an incentive to steer their clients towards them — that the industry really started to take off.

The reality is the vast majority of Canadians still invest in mutual funds because it is what they know and what they are comfortable with, but the tide is shifting

And take off it did, with mutual fund assets surging from $25 billion in December 1990 to $426 billion in December 2001 to more than $800 billion in 2012, according to industry figures. Meantime, the number of mutual funds on the market proliferated into the thousands, representing literally every conceivable investment strategy and sector both at home and abroad. The birth of the deferred sales charge, where a trailing commission is paid up front but the investor is locked in, certainly didn’t hurt either, notes Dan Bortolotti, editor of the Canadian Couch Potato investing blog. “The deferred sales charge was a brilliant marketing tool,” he says. “It is egregious to investors, but it has been very effective at making assets sticky.”

Egregious because, unless investors looked very closely at the legalese in the offering document, they didn’t actually see what the advisor collects by putting them into such investments in the first place — nor for how long, Bortolotti and others note. And they still don’t, despite rules and efforts to ensure they do. “A mutual fund salesperson is legally obligated to explain their compensation when a client is signed on; in theory an investor is supposed to be told about deferred sales charges, fees and what the advisor is getting,” Bortolotti says. “In practice, I don’t know how much that is actually happening.”

It’s equally egregious because the combined fees for mutual funds here are still among the highest in the world, according to a 2013 Morningstar report, which found that Canadian mutual funds routinely carry management expense ratios (MERs) of between 2-3%. (Industry groups argue the report wasn’t an apples-to-apples comparison because what the manager gets and what the dealer gets is bundled, whereas in the U.S. the fees are only calculated by what the manager alone gets.)

For their part, investor advocacy groups including Advocis, the Financial Advisor Association of Canada, believe things are just fine the way they are. They argue that without the expertise of financial advisors, investors would be worse off. And the only way those advisors can continue providing the level of expertise Canadians are accustomed to is with something close to the status quo. And, they argue, advisors do share the fee structure upfront with their clients. As recently as late December, Advocis in particular was still championing a measured approach that would avoid potentially “devastating consequences” that new obligations on advisors would have, not to mention the removal of investor choice in how they pay for financial services.

Other advocacy groups take a different tack. The Canadian Foundation for Advancement of Investor Rights (FAIR Canada), like DeGoey and others, has called for an outright ban on trailer fees, saying they create conflicts of interest by giving advisors incentives to steer their clients into high-fee funds instead of low-fee alternatives.

The Ontario Securities Commission’s Investor Advisory Panel, established to give a recommendation to the Canadian Securities Administration (CSA) on how the whole fee-based system might be overhauled, has different thoughts on how advisors should be compensated, and how they should disclose that compensation to their clients. It wants changes put forward sooner rather than later. “While we are fully committed to thoughtful, careful analysis and measured regulatory response, we believe that the slow pace of reform in Canada is unacceptable,” panel chair Connie Craddock said in late December. “It’s time for Canadian regulators to move beyond discussion and study and raise the bar on investor protection.”

To be sure, those on the mutual fund side of the coin are quick to point out that nothing in this world is free. Just as real estate agents make money vetting properties, overseeing transactions and representing the best interests of their clients, so, too, can and should advisors get paid for vetting client portfolios and advising how best to allocate capital for long-term growth. Whether it comes in the form of an upfront commission or something that is deferred is irrelevant, they say. “There always has to be an incentive for an advisor to deliver service,” says Joanne De Laurentiis, CEO and president of the Investment Funds Institute of Canada, which represents the country’s fund managers and distributors. “The question is whether it is clear to the investor that there is payment for that.”

For many, the answer to that question is a resounding no. Despite being required to explain to clients upfront how things work, the unspoken assumption is that the majority of investors don’t have a clear understanding that the house is giving the dealer a cut — in some cases, before the cards have even been dealt. There is also the issue of objectivity: are advisors swayed to steer their clients into mutual funds that pay trailing commissions at the expense of mutual funds and other investment products such as ETFs that don’t? In other words, the rules seem to encourage the players to sit at specific tables.


DeGoey points out several mutual fund companies that have what he deems great products and great historical returns and yet have only attracted a fraction of assets — including Mawer Investment Management, Steadyhand Investment Funds, Beutel Goodman, Mackenzie’s Saxon group of funds, Leith Wheeler, Chou Associates Management and others — are not household names for a very simple reason: They don’t pay a trailing commission. “These are all really good fund companies, but their assets among advisors round out to nearly zero,” DeGoey says. “Why? Because these mutual fund companies pay nothing or next to no trailing commission, while the rest pay 100 basis points.”

To theoretically put an end to perceived advisor bias as well as make the fees advisors charge for their services more transparent, both Australia and the U.K. have banned trailing commissions outright. Britain eliminated them a little over a year ago, forcing advisors to instead charge an upfront fee for their services. Australia did the same thing last summer. The CSA, the authority governing Canada’s provincial and territorial securities commissions, is contemplating enforcing similar rules that would change the way investors here see how much they pay for what. Options include a new do-it-yourself class of funds with lower fees.

But those in the industry think an outright ban on trailing commissions is too much. Which is where the so-called CRM, or client relationship model, rules come into play, or, more specifically, CRM 2. Enacted by the CSA last July, the portion of the new rules that will most impact mutual fund investors and advisors will be rolled out in 2016, when client statements will have to provide a breakdown of all the fees and expenses paid, including the trailing commissions that advisors get.

For IFIC and others that represent the mutual fund industry, CRM 2 will provide the same if not better disclosure for investors, and still keep the current system of how advisors are compensated intact without following in the unproven footsteps of the two countries that in their members’ view may have acted a bit too rashly. “As an investor, what I need to find is exactly how much I am paying in dollar terms, and then what is the performance — what have I gotten for that money,” De Laurentiis says. “We have the luxury in Canada of seeing whether the banning of those commissions outright is achieving the results that were intended.”

They also argue that things have already shifted. A 2012 report by Investor Economics done on behalf of IFIC found that a full 98% of mutual fund assets did not attract upfront charges and did not incur disposition costs, whereas between 75% and 85% of all fund sales in the 1990s were made up of back-end load units. That’s perhaps true, dissenters say, though front, back or deferred, the industry still diverts fees to advisors, whether the investor is truly aware of it or not and irrespective of whether the investor even needs the advice. “I don’t understand how making something opaque transparent is going to make costs go up, or reduce the quality of advice,” DeGoey says. “The real solution to my mind is to eliminate the little asterisk beside the product that reads, ‘From among those I am licensed to sell, and who pay me a trailing commission.’”

While the mutual fund industry grapples with inevitable change, the ETF industry has quietly gone on the offensive, looking to capture a bigger piece of the pie, of course, but also to point out that many ETFs offer the same if not better investment returns at a fraction of the cost of mutual funds. Where they have stopped short is saying that ETFs are, or should be, a replacement for mutual funds. “There is a place for both mutual funds and ETFs in investors’ portfolios,” says Mary Anne Wiley, managing director and head of iShares Canada, part of BlackRock Asset Management Canada Ltd. “The reality is the vast majority of Canadians still invest in mutual funds because it is what they know and what they are comfortable with, but the tide is shifting. More investors are coming to their advisors asking about ETFs, and more advisors are looking to add ETFs into their clients’ holdings.”

Part of the reason the tide is shifting is education, which, in turn, is leading to more awareness and more investment. The banks and investment firms that provide ETFs have been relentless in extolling the virtues of these products: the ability to trade them like stocks; their low-cost structure; their diversity in terms of replicating indexes and holding multiple securities; and their more recent expansion into the active management space, where a real-life manager will press the default buttons to ensure the strategy, and the capital, remain safe. Of course, they take a few shots at the mutual fund industry on the management expense ratio front. Mutual funds have for years charged MERs in the 2%-and-up range, while the ETF industry has waged war on itself by looking to best one another with the lowest possible MER. They also tout their transparency, since ETFs do not front load or back in any kind of deferred sales charge.

But unlike the mutual fund industry, the ETF world has taken the ‘let’s all get along’ approach, advocating a ‘barbell’ effect where low-cost ETFs on one side are balanced with actively managed mutual funds on the other, thereby creating a more diversified portfolio for the investor and reducing overall expense. Yet the vast majority of retail investors still stick with mutual funds, notes John Gabriel, an analyst at Morningstar who focuses on both the mutual fund and ETF spaces in Canada, and it comes down to a very simple reason. “It’s not that the Canadian marketplace makes mutual funds attractive to investors. It’s that the Canadian marketplace makes mutual funds attractive to advisors,” Gabriel notes. “There are powerful incentives — trailer fees in place — that encourage advisors to put clients into mutual funds.”

To be sure, there is another more technical reason why ETFs still only command a fraction of the Canadian investing assets that mutual funds do: the vast majority of advisors in Canada aren’t allowed to sell them. Investment advisors in Canada can be licenced by either the Mutual Fund Dealers Association (MFDA) or the Investment Industry Regulatory Organization of Canada (IIROC). MFDA advisors can sell mutual funds and nothing else. Only those who are IIROC-licenced can recommend and sell individual stocks or ETFs. A 2012 report by Advocis suggested MFDA advisors outnumber their IIROC counterparts by about four to one, although it’s difficult to quantify with hard numbers.

Such a separation made sense when there was a clear distinction between mutual fund advisors and stockbrokers. But the emergence of ETFs has made it more difficult to justify, notes Pat Dunwoody, executive director of the Canadian ETF Association (CETFA), who along with Sandra Kegie, her counterpart at the Federation of Mutual Fund Dealers, has been lobbying for MFDA advisors to be able to offer ETFs irrespective of whether or not they have IIROC designation. “From a structural standpoint, there is really no difference between a mutual fund and an ETF, other than one trades on an exchange and the other does not,” Dunwoody says. “We believe MFDA advisors should be able to sell ETFs, and we are working on a plan that we believe will allow them to do so — this year.”

Som Seif, who founded both Claymore Investments, which was sold by backer Guggenheim Investments to BlackRock in 2011, and Purpose Investments Inc., which he launched last year, has made his mark championing that Canadians pay too much for too little when it comes to their investments, especially mutual funds. “The debate isn’t about ETFs versus mutual funds; it is about high cost versus low cost,” he says. “The question really is: Why are people paying a lot for fees? And why do people continue to buy high-cost active mutual funds that generally are not providing a great outcome when it comes to fees or returns?”

Part of the solution, Seif says, is for active managers to start charging less, something that to date hasn’t been necessary in Canada because investors are still willing to pay what he and many others see as too-high fees. Another part of the solution stems from something he has done at both Claymore and Purpose: DRIPs, PACCs and SWPs, acronyms for distribution reinvestment plans, pre-authorized cash contribution plans and systematic withdrawal plans, all of which can be done as ETF shares or as mutual fund shares. “The small investor needs to have access to ETFs in the same way the big investor has, and this has long been the way to do it,” he says. “There is nothing stopping an advisor or broker from steering a client towards one of these options.”

To be sure, the tide will likely continue to favour mutual funds over ETFs through this year’s RRSP season if for no other reason than advisors will continue to push their clients towards them, and because the banks that most Canadians use will be hard at work encouraging them to sink a bit more money into them. Over the long term, however, most on both sides of the fence see imminent and significant change ahead: Convergence, for lack of a better term, where the bottom line — cost — will supersede all else.

“The industry needs to evolve, and it will,” Seif says. “It’s like a six-year-old growing up — maybe now it’s a teenager, but it’s still a young pup, and going through its teenage crisis. But when it becomes an adult, the ETF industry will be a very big industry, and it will exist alongside the mutual fund industry.”


About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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