The investment fund industry would have you believe that banning embedded commissions – or trailer fees – on mutual funds will create an advice gap. The thought being that a commission ban will cause thousands of financial advisors to flee the industry and leave small investors, those with portfolios under $100,000, without access to quality financial advice.
This purportedly was the case in the U.K., where the number of financial advisors fell from 40,000 to 31,000 after fees were unbundled from investment products in 2011.
Here’s the thing. This advice gap argument is bullshit because small investors already get screwed. Let me explain:
The so-called advice gap
The typical way for a small investor to get started is to meet with a financial advisor at their bank or at an investment firm such as Investors Group, Edward Jones, Sun Life, or *shudders* Primerica.
A good advisor will assess the client’s overall financial situation before diving into investment recommendations, however ain’t nobody got time for that when they’re trying to meet company quotas and sales targets.
Instead, advisors set-up their clients with cookie-cutter portfolios of mutual funds suitable to their risk tolerance and encourage them to make regular automatic contributions. The mutual funds likely come with management expense ratios (MER) of 2 percent or 2.5 percent, from which the advisor is paid an ongoing trailer fee or commission of between 0.25 percent and 1 percent.
The investment fund industry says the trailing commission is the most effective way for small investors to receive financial advice. This may be true, to some extent, but the problem is most small investors receive little to no advice at all. Instead, they maybe get a phone call once a year during RRSP season encouraging them to make a contribution.
‘Our financial adviser is such a nice man. Every year he takes us out for a wonderful dinner. I wish we could pay him in some way.” This is an exact quote from a friend’s mother. It’s a classic example of a Canadian investor not knowing what he or she is paying. – Steadyhand’s Tom Bradley.
The focus is 100 percent on product sales, not advice. But an investment portfolio is not a financial plan. Young investors, and those with modest portfolios also need help managing their cash flow, creating and sticking to a budget, prioritizing their short, medium, and long-term goals, paying off debt, optimizing their taxes, and reviewing their insurance needs.
These things are not being offered to small investors now. The advice gap already exists. Now let’s say regulators finally implement the long-awaited commission ban and it plays out just like the investment fund industry predicts. Which advisors will leave the industry? Perhaps the ones whose sole business model relies on getting hundreds of small investors to pay ongoing trailer fees on their mutual fund investments.
Is this such a bad outcome for small investors? Hardly. Right now they’re paying some of the highest fees in the world for underperforming mutual funds without getting any proper financial planning advice.
Thankfully, while regulators have been mulling this ban for more than 20 years (seriously), new options have entered the market to make investing easier and more accessible for all types of investors.
Robo-advisors are disrupting the traditional investment management business, allowing investors to build a low-cost portfolio of ETFs and rebalance it on the cheap. Wealthsimple, Canada’s leading robo-advisor, recently announced that it has over 30,000 clients and more than $1 billion in assets under management.
Online discount brokerages cater to the do-it-yourself investor and these robust services have become cheaper and easier to navigate in recent years with more of a focus on user experience.
Finally, the emergence of fee-only financial planning not only shows that Canadians are willing to pay upfront for financial advice, it also highlights the importance of offering conflict-free advice that is not tied to product sales.
It’s clear to me that the ‘advice gap’ is simply a desperate attempt from a dinosaur industry to keep things status-quo. Understandably, there’s a lot at stake. As of April 30th, 2017 Canadians held $1.42 trillion in mutual funds.
Yet there’s overwhelming evidence that trailer fees – the current way most financial advisors gets paid – create a conflict of interest and lead to worse outcomes for investors.
If banning embedded commissions means that thousands of advisors leave the industry then so be it. It’s likely this is the bottom rung of advisors – the order takers and product pushers – that don’t offer much value beyond slinging expensive mutual funds.
Any good advisor worth his or her salt provides financial planning advice in addition to portfolio management and investment advice. But odds are these advisors only work with high net-worth clients. For the rest of us, I recommend a two-pronged approach:
- Use a robo-advisor to manage your investments.
- Hire a fee-only financial advisor to create a financial plan for you.