Incentives and conflicts of interest matter – more evidence for Canadian investors

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“When you rely on incentives, you undermine virtues. Then when you discover that you actually need people who want to do the right thing, those people don’t exist because you’ve crushed anyone’s desire to do the right thing with all these incentives.” – Barry Schwartz, psychology professor and author

“If I, taking care of everyone’s interests, also take care of my own, you can’t talk about a conflict of interest.”  – Silvio Berlusconi, Italian media tycoon, former Italian Prime Minister, convicted tax fraudster

When we speak to people about investing we stick to the mantra that long term success in investing is less about outsmarting the market and more about accepting the market and staying out of trouble.  Trouble usually manifests itself in one of the following ways:

  • high and/or hidden fees
  • lack of diversification
  • inappropriate investments for your risk profile
  • under-utilization of tax efficient accounts
  • conflicts of interest between you and those that want to sell you something
  • your own behaviour

Conflict of interest is an interesting one.  Many Canadian investors who invest in mutual funds purchase them from an advisor who is paid a commission for selling them those mutual funds. Commissions are how a large number of financial advisors in Canada are paid for the advice they give.  This situation gives rise to the potential for conflict of interest between the end investor and their financial advisor.  While the presence of a commission based arrangement does not automatically mean advisors will put their own interests ahead of those of their clients, you could see how the potential is there.  For example, equity mutual funds often pay higher commissions than bond mutual funds.  Might this commission structure influence the advice an advisor gives on asset allocation between equities and bonds?  Possibly.

The issue of incentives and conflict of interest in the investment industry is currently a hot topic in Canada and one regulators are keen to tackle in the near future.  Other countries such as the United Kingdom and Australia have sought to protect investors by banning certain commission practices.  While the US has not yet banned certain commissions practices, education, competition and innovation from market leaders such as Vanguard and others seem to have provided end consumers with more abundant conflict-free choices when it comes to their investments.  Currently, Canadian investors pay some of the highest mutual fund fees in the world, much due to the presence of embedded commissions.

In its efforts to determine the best policy action for Canada, the Canadian Securities Administrators (CSA) commissioned an independent study on the impact of fees on mutual fund performance and fund flows.  That report released last week – A Dissection of Mutual Fund Fees, Flows and Performance –  is not an easy read but generally concludes that a) the presence of commission fees does indeed impact how advisors’ direct their clients’ investment dollars and b) the end result is bad for investors in terms of investment performance.  Perhaps this is the final evidence the CSA needs to take decisive action.   Perhaps they’ll need more time.  In the meantime, we hope education, competition, innovation and the growth of better options help Canadian investors to make more sensible decisions for themselves.