Does Canada need more investor education, or more advisor education?

At the end of a recent meeting, a client asked me if I ever wonder why everyone in Canada isn’t investing in low cost index based funds.  The conversation usually goes that way when people hear the story of a passive investment philosophy and fee based business model, but it isn’t something that I wonder about.  The vast majority of Canadian investors use a financial advisor to invest, and about 75% of Canadian financial advisors are only licensed to sell mutual funds.  Getting mutual funds licensed is much easier than getting securities licensed, and finding a commission based job selling mutual funds is much easier than finding a job with an independent fee-based brokerage firm.  I started my career in financial services as a commission based mutual fund salesperson.  I will be forever impressed by the quality of sales and financial planning training that was given to newly recruited financial advisors, but there was a massive disconnect when it came time to make an actual investment recommendation. 

Advisors with next to zero knowledge of financial markets are expected to choose from thousands of available funds while under pressure to make commissions.  Making it worse for the client is the fact that only high-fee mutual funds pay the commissions that new advisors need to make a living.  With strong sales skills and a knowledge of financial planning the product becomes less important and being a financial advisor becomes a matter of managing relationships, something that people with little to no knowledge of financial markets can do successfully.  A highly skilled and motivated sales force that does not always fully understand what they are selling, and an investing public with minimal financial education, make it obvious to me why Canadians have been relatively slow to adopt low-cost tools like index mutual funds and ETFs.  I meet plenty of people who are fed up with the fees they have been paying and the service they have been receiving, but the market is still slow to get away from high fee mutual funds sold by commission hungry financial advisors.

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Insights of a First Year Mutual Fund Representative

I wrote this letter to my managers within my first four months of being an insurance and mutual fund representative.  In reflection, I find it interesting that almost exactly a year later I have found myself in a firm that recruits and trains advisors in the manner that I describe here.  In my opinion, this type of model will have to be the future of the financial advisory business, especially when the changing regulatory environment is considered.  When I wrote this, I was not aware of the fee based model.  The fee based model is far more conducive to operating in the manner that I describe below, which is likely one of the reasons why the embedded commission model is under so much fire today.


The letter:


The broad expectation that I have for my current position is that I am constantly learning and fuelled by activity.  I will go into more detail later in this document.  When I entered into the position I had a vision of it being similar to a high level law practice.  I will explain what this looks like in my mind and then draw parallels to show how it applies to a high level financial advisory practice.

After performing casual research by speaking with a corporate lawyer and two litigators (one in family law one in intellectual property law) I have learned that when entering into a firm as an associate, excess clients are passed from the partners to the associates to give the associates an opportunity to learn and build their practice.  Associates are allowed and encouraged to bring in their own clients, but the high level business from the partners is what allows them to gain the type of experience required to add value to the firm; clients passed on from the partners also allow the associates to build a client base that fits with the image and quality of the firm.  An analogy that I discussed with one of the lawyers that helped me understand how a high level law firm works compared the way that financial advisors currently enter the business to a lawyer opening up their own law firm on the street; they are starting a practice with no brand equity, no referral base, and no high level cases to work on to gain the experience needed to become a high level practitioner.  This model is not conducive to building an elite practice.  Partners have spent years, if not generations, building a name and a referral base that brings in clients.  This difference in the way that a lawyer enters the business compared to the way an advisor enters the business explain the disparity between the average level of recruit entering a law firm and the average level of recruit entering an advisory firm.  This model also increases the barriers to entry for an advisory practice.  The current model allows managers to maintain relatively low standards when they are hiring new recruits for multiple reasons: new recruits are difficult to find due to the nature of the business, and the high turnover rate is somewhat justified by the relatively low level of investment by the firm.  It is a vicious circle and a chicken before the egg type situation.  If a model representing a law firm were adopted then the quality of advisors coming into practice would increase.  In the event that advisors knew they would be getting clients upon beginning to practice the business would be far more enticing for compensation and experience purposes; referring to my previous analogy, lawyers are far more likely to join an existing firm than to start their own right out of law school.  The reasoning of a lawyer choosing not to start their own practice is similar to that of a high level professional considering financial advisory; it is necessary to start a business from the ground up.  The alternative law firm hybrid model also increases the investment from the firm which will inevitably result in higher risk, but also greater reward.  The risk of high turnover will be mitigated by replicating the hiring standards of a law firm with an articling process, and a progression into the business.  The reputations of advisors in our business are damaged by the lack of an articling period and the rapid succession into practice.  If lawyers were able to write one two hour exam and begin practicing, the public would be as skeptical of them as they are of advisors.

In our discussion yesterday we referred to the trials and tribulations that people will go through to be analysts for Fidelity.  We failed to discuss some key aspects that make this possible, and the ways that they can be applied to revolutionize our business.  The people putting themselves through hell to become analysts for Fidelity are the cream of the crop.  They are top students from top schools competing for a top position that, if achieved, is guaranteed to come with a large payout and huge opportunities for the future.  In contrast to this, financial advisors often enter into the business with little idea of what it is that they are getting into, high hopes for the potential of income, and unrealistic expectations for what the first few years will be like.  Financial advisors are often second career people looking for higher income, or university graduates that were unsure of what they would choose as a career.  It is very possible for advisors to go through their career never making one tenth of what an analyst at Fidelity will make, while continuing to scramble as if they were fighting for a spot.  It is a difficult expectation for the firm to hold that individuals with high income potential will walk into a business with such a high failure rate when they could be entering into fields with guaranteed income.  I understand the argument that the income potential in this business justifies the initial risk, but imagine the advisors that are being overlooked due to being averse to the risk.  Changing the broad business model to the law firm-like approach will make gaining a spot in this firm a cherished opportunity that graduates with high expectations for themselves and their careers will compete for.

The law firm business model sounds attractive and flashy, but is it feasible to apply this model to an advisory practice?  Lawyers are paid on a salary with an opportunity to earn a bonus based on their performance and the revenue that they are able to produce; billable hours are charged to the firm and used in analyzing the performance of associates.  In the event that associates are brought into cases with a partner their billable hours are combined with that of the partner.  The billing system records how files come in and associates are paid a bonus between .5 and 2% of the total bill for that case.   This occurs if the associate refers a case in, or if they are present in the initial meeting and throughout the case.  Associates are given “sales” targets that must be met using either billable hours or set block fees.  The cases handed to associates by partners count towards fulfilling these quotas; the same system could easily be applied to DSC sales and aum, using commissions and assets instead of billable hours.  From the samples that I took, it is common for first year associates to have to fulfill between 1200 and 1800 billable hours per year.  This does not include administrative work, so it is apparently very difficult to achieve these quotas.  Again, this system is very relatable to commissions.  Advisors would still be motivated to sell and gain clientele to meet their quotas, while having the safety of a salary.  When a lawyer is awarded a position in a firm they are required to go through a period of articling which lasts 10 months; they are paid a salary of approximately $40K during this time.  The next step is to become a first year associate, during which time they are compensated with a salary of approximately $65K and incentives based on activity.  A small percentage (.5-2%) of the business that a first year associate brings to the office is paid out to them.

I understood entering the business that it would not look like what I have described in this document, but I certainly did expect it to be somewhere between what I have described and what it is.  I believe that if we are able to build a model that operates in line with what I have described, we will be able to bring in higher level advisors and bigger clients, take advantage of the concept of functional specialists, and create young advisors that operate on a level that usually takes a life time to achieve.

Understanding that there is a small chance that any of this will actually happen, my expectation going forward is that I will be included on large cases, I will be compensated according to the level of work I am performing, which may not be directly related to premium submitted, and I will be given the type of guidance and structure that an articling lawyer would receive.  It is my preference that I am put on a salary as my current lifestyle cannot be maintained with my level of pay, and the clients that I am attracting to try and pay the bills are not conducive to building the type of practice that I envision.  A structure similar to a first year associate in a law firm, with bonus based on performance, is preferable.

A final note that I hope will make all of these ideas make sense when applied to our office:  There are a select few prestigious law firms that were built by charismatic people with affinities for both law and business.  They have built practices that bring the biggest law cases in the world to them because of the name they have built.  These firms employ massive amounts of highly intelligent and well respected lawyers which allow the firm to attract and handle even more business and bigger cases.  If every lawyer at Gowlings had opted to open their own practice instead of joining the firm, not only would they suffer from having to start from scratch, but the firm would suffer due to decreased capacity and an inability to grow.  Asking financial advisors to start from scratch every time they enter the business is inefficient.  A charismatic and talented advisor should be able to build a practice, and then continue to grow it by adding other advisors that he is able to pass his extra cases to and increase the capacity of his practice.  There is a huge difference between having people on a sales team and having people integrated fully into a practice.  Financial advisory fits so well into the model of a law firm; I believe that shifting to this model is the future of the business.

Commentary on the CSA's recent status reports (CSA Staff Notice 33-316 & 81-323)

The Canadian Securities Administrators have been reviewing two different, but related issues for over a year now.  Both of the topics receive a significant amount of coverage in the media; they are Mutual Fund Fees and the Appropriateness of Introducing a Statutory Best Interest Duty When Advice is Provided to Retail Clients (making it the law for advisors to act in the best interest of the client).  I just want to express what I feel were the highlights of both of these papers, and offer my commentary.  I have been on three sides of this equation (investor, mutual fund salesperson, and fee based investment advisor), and as such I think that I can offer some unique insights.  The stakeholders in this discussion have been identified as the mutual fund industry, and the investors.  Their points of view are summarized below.

The Mutual Fund Industry

  • There is no evidence of investor harm that warrants a change to the mutual fund fee structure in Canada
  • A ban on embedded compensation will have unintended consequences for retail investors and the fund industry, including:
    • a reduction in access to advice for small retail investors,
    • the elimination of choice in how investors may pay for financial advice, and
    • the creation of an unlevel playing field among competing products and opportunities for regulatory arbitrage; and
  • We should observe and assess the impact of domestic and international reforms before moving ahead with further proposals.

The Investors

  • Embedded advisor compensation causes a misalignment of interests which impacts investor outcomes and should be banned;
  • Investors should at a minimum have the true choice to not pay embedded commissions;
  • We need to implement a best interest duty for advisors; and
  • We need to increase advisor proficiency requirements and regulate the use of titles.

The statement that there is no evidence of investor harm that warrants a change to the mutual fund fee structure is just about the worst reason that I have ever heard to allow a regulatory policy to remain the same.  A practice should not be allowed to continue because no harm has yet been caused by it.  My point here is especially salient when we consider that other countries across the globe are changing their mutual fund compensation structures because they have had problems in this area.  The UK and Australia have prohibited conflicted advisor remuneration "in response to unique consumer protection gaps and situations including mis-selling scandals causing harm to investors, which are not present in Canada."  So despite serious problems with the exact same thing in other countries, we don't need to change it in Canada because nothing has happened yet...seems like a good idea.

I do agree that changes to the regulations could have ramifications beyond the scope of their intentions, but I do not think that these ramifications would be a bad thing.  There is some merit to the statement that unbundled mutual fund fees would reduce access to financial advice for people with small (less than $100K) portfolios.  It would not be beneficial for either the client or a fee for service advisor to enter into a relationship with only a small amount of capital to invest.  As it stands today, small retail investors are in a situation where they are limited in their options beyond investing in mutual funds with high expense ratios if they want financial advice - the only reason that financial advice is affordable with the current embedded commission model is due to the existence of the deferred sales charge (DSC).  The DSC is exactly what it sounds like; instead of paying a bunch of money (5-6% of the account) up front, you pay it behind the scenes over five or six years and never even notice that the advice you received cost anything.  This is a great idea for the advisor as they receive remuneration at the time of the sale.   It also seems to make sense for the investor because they never see the money leave their wallet, until they want to move their account or withdraw their funds before the six years is up.  If the money does not stay invested for the full deferral period, the client is on the hook to pay the fund company back for the money that their advisor received at the time of the sale.  Another issue in this area is that not all mutual funds have the DSC option; in my experience, funds with low fees that do not involve predictive management or large amounts of trading cannot be purchased in this manner.  So... small investors that want advice are likely to have their money invested in expensive funds that allow their advisor to apply the DSC to make it worth their while.  Knowing that information, I'd say that  although small investors can afford advice in the current environment, the advice that they are getting is highly biased towards funds that can be sold with the DSC.

The industry has stated that they do not think that there are conflicts of interest with the embedded fee structure because all types of mutual funds in Canada have comparable trailing commissions.  On this topic, I can speak from direct experience.  When I was operating on the MFDA platform I was very limited in the funds that I was able to offer.  Yes, there were hundreds upon hundreds of mutual funds with high expense ratios claiming to be able to beat the market available to me and the people in my office, but as I started to shift my thinking towards the use of ETFs and index tracking mutual funds I learned that I could not access them.  I remember discovering TD's index funds and being told I shouldn't use them because I couldn't make any money, and I wasn't able to use Dimensional Fund Advisiors because my dealer did not acknowledge them as a supplier.  It is true that most equity mutual funds with high fees have the same trailing commissions, but I would argue that when advisors are limited to using these funds it is difficult to act in the best interest of the client.  Based on my experiences I can safely say that the clients' best interests are not being put first.  Of course, this shouldn't come as a surprise.  In the current regulatory environment investment recommendations only have to be deemed suitable for the advisor to be legally off the hook.

This lack of a requirement to act in the best interests of the client, or lack of a fiduciary standard, is an issue on more than one level.  To open the discussion of the lacking fiduciary standard I first need to explain the educational requirements in place for an advisor to begin operating in this industry.  In order to sell mutual funds, and call yourself an advisor, it takes one exam requiring a 60% to pass and a 90 day supervised training period.  The exam is designed to take between 90 and 140 hours to prepare for.  So with that said, how is someone supposed to know if they are acting in the best interests of their client when they barely know what they are selling? During the 90 day training advisors aren't even trained to put the interests of the client first, they are trained to make suitable investment recommendations. Using the UK as an example, when they prohibited embedded commissions and increased regulations there was a drop in the number of advisors because some of them could not meet the proficiency standards put in place.  To compound this issue, the CSA cited a study stating that most investors already think advisors have a legal duty to act in their best interest.

The fact that there is a debate around whether or not advisors should have a legal duty to act in their clients' best interests is a little bit silly right?  How is this even a question?  The industry argues that the cost of an investment product should not determine suitability; although an advisor may place their client's investments in a more expensive fund they may have done so because the more expensive fund is expected to perform better in the long run...what?  I don't even want to touch that one.  History tells the story of expensive funds outperforming the market better than I can.  The industry also poses that the introduction of a fiduciary standard will give people less incentive to educate themselves on investments and place more reliance on their advisor.  We certainly wouldn't want clients to forgo educating themselves in favour of taking advice from their professional advisor.  I of course say that in jest, but it may hold more truth than it should with proficiency standards at their current level.  

Another argument that the industry poses against implementing a fiduciary standard is that it would be expensive, and these costs would be passed to the client.  To this I say that clients are better off paying more for advice when the advice has their best interests in mind than getting cheap advice that quietly pads the pockets of their advisor.

One of the biggest problems the mutual fund industry would face if a fiduciary standard and unbundled commissions were implemented is that they only funds.  If the most suitable product for a client was not a mutual fund, or like in my experience the most suitable product was a mutual fund without embedded commissions, how can the client's best interests be served?

Personally, I think that the fact that there is a debate around these issues at all is ridiculous.  I worked with some great people when I started in this business on the MFDA platform, but it did not take me long to realize that there were many pieces missing if I was going to be acting in the best interests of my clients.  There a lot of good people in this industry that genuinely think that they are doing what is right for their clients; it is an issue of education on the part of the advisor. I look forward to seeing how all of this turns out, though it doesn't make any difference to me.  I am already operating on a fee-only basis within a firm that has a self imposed fiduciary standard.  

Everyone else will get it right eventually.

Where is the Value?

The information systems that have become fully integrated in our lives have changed the nature of business.

The ability that people have to do their own research about the best product for their needs, how to implement it, and where to find it at the lowest cost has created a new type of business; the idea of cost-cutting discount stores has taken off.  These establishments cut their operating costs to a bare minimum so that they are able to pass the savings on to the customer.  This idea works well for commodities, and companies like Walmart have been able to position themselves in such a way that they actually add value by making consumers feel satisfied that they have made their purchase at the lowest possible price.  The cost cutting business model does, however, come with an indirect price; stores like Walmart and Costco are not full of eager employees waiting to help you.  The lack of service isn't a huge issue when it is commodities being purchased, but what if the goods become more specialized?  I know that the last time I went to buy a TV it took me thirty minutes to find an associate to help me, and when I had someone to help me they did not have the information that I needed to make an informed decision.  This lack of service and expertise is not the fault of poor management, it's the fault of the consumer.  The price elasticity of demand forces brick and mortar retailers to reduce their fixed costs to try and compete on price with online stores.  This combined with the wide availability of information tends to make people think that they can become experts and do not need to seek out the recommendation of a professional.

The same phenomena can be observed in the financial services industry.  There is a vast quantity of information available to people about the financial markets, financial planning, and the different financial products that are available to consumers, and with the development of discount brokerages, it is possible for someone to spend the necessary time doing research to put themselves in a position to successfully plan for their financial future while minimizing costs.  So if the information is available, and people are able to make their own investment decisions, why do financial advisors and financial planners exist?  They wouldn't exist if they weren't able to provide a service that people see as valuable, but where is the value?

*An important note before I discuss the value that these professionals provide is that not all of them do in fact provide value.  It is the nature of compensation in the business that makes this possible.  In my previous posting I discussed the difference between an advisor and a salesman.  With the impending fee disclosure that will be implemented in the next few years, the clients of salesmen will start to wonder what exactly they are paying for when they see the fees on their statements; these clients will start migrating away from salesmen and toward advisors.


Whether an advisor is fee based or commission (trailer fee) based, they will usually charge between .5 and 1% of assets as a management fee,  so what should you be expecting in return?

  1. A Plan - The single most valuable service that a financial advisor can provide to their client is the development of a financial plan.  The clarity that can be gained from understanding how much needs to be saved in order to retire with a certain level of income is unparalleled.  A comprehensive financial plan will also address the insurance needs necessary to maintain the integrity of the plan in unexpected circumstances, and government benefits that the clients expects to receive as they age.  If the plan was something that could be put in place and forgotten about it would make a lot more sense to pay an upfront fee, but this is not the case.  Market returns and changing life circumstances can have an impact on the way that the plan is carried out.
  2. Systematic Review - Administering a financial plan is something that requires knowledge, experience, and confidence.  When the financial markets had a downturn in 2008 the decision to stay invested was a difficult one, and how to proceed in the market in the coming years was equally difficult.  It is the responsibility of the advisor to restructure the plan to show what needs to happen to stay the course, and to provide the confident advice that will allow the client to have peace of mind.  A minimum annual review should be expected, and more frequent reviews should be available if life circumstances change.
  3. Expertise and Knowledge - When you are making the decision not to take your finances into your own hands, but to pay someone to advise you, it is an obvious expectation that the person you are paying should be educated in the field of finance.  The intricacies of financial planning should be fully understood by the advisor to ensure that your trust is being put in the right place.  Finding the right advisor with the right skill-set and knowledge base is a challenge in itself, but I will address my thoughts on that in another post.

When people ask me why they need a financial advisor, my answer is that they don't.  Having a financial advisor is a choice.  It is a choice to hire a professional to manage your finances and spend the time to plan your financial future with you.  This is a service that you should expect to pay for.   I would never tell someone that they need to have a dentist either, but it makes more sense to me to have my annual cleaning and maintain the health of my teeth than to wait until an emergency arises to seek out help.

When it comes to managing your money, if you can do it on your own that's great.  If you have your own life, career, and family to deal with, working with a professional can be the best option.