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Morningstar | Continued Use of Embedded Trailers a Net Positive for Canadian Asset Managers

With both narrow-moat IGM Financial and CI Financial reporting earnings this week, we have a better sense of the impact the decision to not ban embedded commissions on the part of the Canadian regulators will have on the asset managers. Rather than eliminate the use of trailer fees, the Canadian Securities Administrators have proposed new rules for broker/dealers and financial advisors aimed at helping them address, and hopefully avoid, potential conflicts with their clients' best interests. The CSA is also calling for the elimination of deferred sales charges (DSC) and want to prohibit broker/dealers that don't make suitability determinations when selling funds from collecting trailer fees (which primarily impacts discount brokerage firms).

While this has been viewed as a win for the industry, given there was no blanket ban on embedded commissions (and no introduction of a best interest standard), we see it as a concerted effort on the part of the CSA to keep the needs of the investment industry and investors in balance, while still leaving the door open for more regulation. For the Canadian asset managers, this was almost the best possible outcome, as embedded trailers have generally allowed them to maintain positions on retail platforms, while also keeping low-cost index-based products (that don't pay embedded commissions) at bay.

AGF Management was first to note that there would be no immediate impact on their business but given that the firm has paid around CAD 38 million out as DSCs the past four fiscal quarters there was interest in that particular proposal. IGM Financial noted that it'll see less of an impact from a banning of DSCs, as it eliminated them from new fund sales at the start of 2017. Management does, however, expect to tweak know-your-product and suitability standards for its advisors to match any new requirements, which is similar to the comments we heard from CI Financial as it relates to its advisory operations.

At the start of June, we put out an Observer, "A Ban on Embedded Trailer Fees in Canada Would Further Widen the Gap Between the Banks and Purer-Play Asset Managers," that noted that the adoption of a ban on embedded commissions would alter the Canadian fund industry in several ways. First, we believed it would force advisors to focus more heavily on investment performance and fund management fees, as they would have to not only justify their advisory fee (which would be completely transparent and billed directly to investors), but also focus on putting clients in better-performing investment vehicles with reasonable fees, as the ongoing compensation they would earn would be more directly linked to client investment performance. We also believed that a ban on embedded trailers would open the door much wider for low-cost index-based products--both index funds and ETFs--which provide investors with market-like returns at more reasonable price points than most active managers. And, finally, we believed a banning of trailer fees could expand the number DIY investors in the Canadian market.

We expected that these changes would put even more pressure on the non-bank-affiliated asset managers, with IGM Financial, CI Financial, and AGF Management all seeing greater focus on their fees and performance as most retail investors would be pushed into fee-based accounts. While the CSA's decision to not ban embedded trailers (nor introduce a best interest standard) works to the benefit of the asset managers, it does not alter the overarching competitive environment that these firms are currently facing, where the balance of power continues to shift more and more toward the Big Six banks--Royal Bank of Canada, Toronto-Dominion Bank, Scotiabank, Bank of Montreal, Canadian Imperial Bank of Commerce, and National Bank of Canada--which have used their position as the largest distributors of mutual funds in the Canadian market, as well as an expansion of their fund manufacturing operations, to compete more heavily on price, taking share from nonbank-aligned firms.

What the decision not to ban trailer fees does do is lift a cloud over the industry and brings a bit more certainty to the path forward (at least for the non-bank-affiliated asset managers) over the next several years. While mutual fund embedded commissions will remain permissible under the CSA's new proposals, they will now be subject to enhanced conflicts of interest mitigation rules (which is more of an issue for the broker/dealers and advisors that work directly with investors). They will, however, be prohibited for broker/dealers that do not make a suitability determination when selling funds to investors (which falls mainly on discount brokerage firms).

Meanwhile, the regulators' decision to ban DSCs simply makes official what has been an accepted industry practice the past several years, as firms like IGM Financial have already backed away from their use in new fund sales. Of the purer-play asset managers we cover, AGF Management has had the most financial exposure to these types of products (with 40% of annual cash from operating activities before the payment of deferred sales commissions being paid out as deferred selling commissions on average during 2014-16), followed by IGM Financial (at 26%) and CI Financial (at 17%). While IGM Financial discontinued the deferred sales charge purchase option for its Investors Group fund offerings, and reduce fees on its no-load series, at the start of 2017, the firm still paid out 29% of cash from operating activities before the payment of deferred sales commissions as deferred selling commissions last year (compared with AGF Management at 36% and CI Financial at 5%).

Banning DSCs completely would be helpful from a cash flow perspective for firms that have generated a greater amount of fund sales via this option, as the asset managers have had to pay commissions upfront and then amortize the cost of the outlay over time (usually seven years). That said, moving away from DSCs could be detrimental to flows, as it is likely to lead to lower sales of products where they've been a prominent feature and could even lead to earlier than expected redemptions. While the full impact will depend on how the regulators lay out their game plan for eliminating DSCs from the investment landscape, we expect to keep a closer eye on AGF Management as the firm has the greatest exposure to these types of products.