Mutual fund trailer commissions are a conflict of interest

Mutual fund trailer commissions are a conflict of interest

November 5, 2015

Professor Douglas Cumming, Professor in Finance and Entrepreneurship,  Schulich School of Business, York University
Professor Douglas Cumming, Professor in Finance and Entrepreneurship, Schulich School of Business, York University.

Mutual fund investors are at a disadvantage because of the way the industry pays commissions.

We have more research that says the same old thing. The industry’s current method of paying commission is not in the best interest of investors.  

Canadian securities regulators commissioned a study that shows how vulnerable mutual fund investors are. Two things were learned and both were bad.  

First, mutual funds that pay ongoing trailer commissions to financial advisors attract more money than mutual funds that do not pay a trailer commission. This applies to all funds, including the ones that have inferior investment returns.

Second, funds that pay trailer commissions have investment returns that are often less than competing funds that do not pay a trailer commission.  

Most Canadians own mutual funds and most mutual funds pay a commission to the financial salesperson.

According to research done by the Canadian Securities Administrators the majority of mutual fund investors are not aware of commissions that are paid to their investment advisor and do not recall commissions paid ever being explained to them.

Mutual funds are often sold with the hidden commission paid at the time of sale. In addition, there are ongoing trailer commissions paid as long as the client continues to own the fund.

Paying for ongoing advice is logical; however, often there is no follow-up advice or any communication.

Paying for ongoing advice that might not be received, in my opinion, is an overpayment. All mutual fund fees and commissions are paid by the fund and therefore reduce the return on investment to the client.  

It is as simple as following the money.

When money is paid as an ongoing commission, there is a financial incentive for those mutual funds to be sold to clients. 

This commissioned method of selling mutual funds is not in the best interest of the investor.

The research was done by Professor Douglas Cumming who teaches finance at York University.

His research will be used by securities regulators to decide whether to change the fee model of how mutual funds are sold.

Mutual fund trailer commissionsChanges to how mutual funds are sold in Canada could include an outright ban on trailer commissions. This has already happened in England and Australia.

Professor Cumming’s research is just one more bit of evidence showing that the current method of selling funds in Canada is broken.

Other information supporting this has been reported in the past.   Professor Susan Christofferson from the University of Toronto had similar findings, based on U.S. data, she released in early 2013. The amount of commissions paid to the financial salesperson appears to be the single largest motivator for a fund to be sold.

Professor Cumming reported funds that paid trailer commissions often had inferior returns. Previous academic evidence has also come to this conclusion.

The greatest predictor of mutual fund returns is fees. Higher fees mean lower returns; lower fees mean higher returns.

It is just a case of simple arithmetic. If investment returns are used to pay an investment salesperson a trailer commission then returns are less.

It is that simple.

Respectfully, it seems as if those who make decisions on regulating the investment business have studied things backwards and forwards since the 1990s. Now is the time to act.

In my opinion, the investment industry needs a major overhaul regarding how fees are charged. A good start would to be abolish ongoing trailer commissions.

Watson Investments
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