Engineering A Better Outcome For Investors

When I worked in the hospitality industry our hotel group placed a large emphasis on the profitability of its restaurants and catering departments. Considerable effort was made to drive overall food costs down while at the same time creating a sales culture that pushed the highest margin items to boost revenue.

One of the most effective ways to do this was through a process called menu engineering. Before hitting it big by turning around struggling nightclubs in the reality show Bar Rescue, Jon Taffer was a highly sought-after speaker and consultant in the hospitality industry. At the top of Taffer’s legendary revenue growth plan for restaurants and bars is the concept of menu engineering. Here’s how it works:

Menu Engineering

Restaurant owners divide their menu items into four main categories:

• Stars – Extremely popular with a high contribution margin. Ideally Stars should be your flagship or signature menu items.
• Plow horses – High in popularity but low in contribution margin. Plow horse menu items sell well, but don’t significantly increase profit.
• Puzzles – Generally low in popularity and high in contribution margin. Puzzle dishes are difficult to sell but have a high profit margin.
• Dogs – Low in popularity and low in contribution margin. They are difficult to sell and produce little profit when they do sell.

The main goal of menu engineering is to steer restaurant customers towards your stars and puzzles (highest margin items) and away from the dogs and plow horses (low-profit items). The way to do that is by using a bit of psychology in the design of their menu.

For example, putting a box around an item on a menu will increase its sales by 20 percent, and shadowing an item on a menu will increase its sales by 14 percent. The serial positioning effect (our ability to remember the first and last items in a series best) means listing profitable appetizers and entrees first and last, since customers are more likely to ignore the middle.

Menu-engineered investments

Customers may not care if their dining experience is being subtlety manipulated by savvy restaurateurs. After all, we go to a restaurant to enjoy good food and drinks in the company of friends and family.

But what about when the stakes are higher, such as in the world of investing and financial advice where the banks and mutual fund dealers are the restaurant owners, carefully crafting a menu of profitable funds, and the advisor becomes the waiter or waitress, steering unsuspecting customers toward the catch of the day (with a side order of segregated funds).

Related: Steak knives, yes. Financial advice, maybe not.

What might a menu-engineered line-up of mutual funds look like?

• Stars – The most popular and profitable mutual funds: most likely a Canadian equity fund or dividend fund with an average MER of 2.42 percent
• Plow Horses – High popularity but lower profitability: most likely a bond fund where the advisor receives a 0.5 percent trailing commission as opposed to 1 percent with an equity mutual fund.
• Puzzles – Highly profitable but low in popularity: most likely includes global funds or a niche fund with an exotic strategy that customers don’t understand. Fees likely in the 2.75 – 3.25 percent range.
• Dogs – Low margin or no-margin products such as index funds, e-Series funds, and F-series funds (less likely to be discussed or even included on the menu).

Revamping the mutual fund fee structure

The Canadian Securities Administration is (still) reviewing our mutual fund fee structure and whether commission-based compensation changes the nature of advice and impacts investment outcomes for the long term.

One study, published by the Brondesbury Group, concluded among other things that commission-based compensation creates problems that need to be addressed. The second study, published by Dr. Douglas J. Cumming, professor of finance at York University, revealed that more investor dollars are steered towards mutual funds that have higher trailer fees – creating a giant conflict of interest.

Related: Ban on embedded commissions coming, despite industry objection

One potential outcome from these studies is that the CSA may look to ban trailer fees altogether. The Brondesbury report looked at the impact of banning commissions and determined that we’d see:

• More sales of lower cost products including lower cost mutual funds and ETFs.
• Less biased product selection from advisors.
• Higher explicitly stated cost for full service advice.
• More use of non-advised or simplified advice (robo-advisor) channels by lower income and lower wealth investors.

Final thoughts

In my view there are three issues to tackle when it comes to reforming the investment industry in Canada and engineering a better outcome for investors:

1. Commission-based advice is riddled with conflict of interest and so trailer fees need to be eliminated.
2. Besides trailer fees, Canadian mutual funds cost far too much as a whole (2.42% for the average equity mutual fund) and need to be capped.
3. A best-interest or fiduciary duty should be established to replace the current (and inferior) suitability standard for investment advice.

I believe the time is right for reform. The so-called advice gap (the argument that banning commissions will mean less advisors to service smaller investors) is overblown as technology (robo-advice) can fill the void at a fraction of the cost.

Pairing DIY investing or robo-advice with a fee-only financial planner can still much cost less than what Canadians are currently paying within the commission-based mutual fund model.

That said, this is an incredibly complex topic and any reform the CSA takes is unlikely to solve all of the issues.

What most experts can agree on is that, whatever the solution, investors must understand they are paying for advice as well as transactions.