Conflicts of Interest in The Canadian Investment Industry

Do you know what your investments cost? You would think that the collapse of worldwide markets would have provided a wake-up call to both governments and investors, but that’s not the case.

As a Portfolio Manager for private wealth individuals in Canada, I come across many intelligent and sophisticated individuals who have little, if any clue as to their all-in management fees with their current adviser. Truth be told, you’d probably need a forensic accountant to discover how much your investment adviser earns from managing your money.

The problem is that all-in fee structures are just not transparent, and the Canadian government (unlike other governments in the UK, U.S, Australia) has shown little interest in forcing the industry to simplify its communication of management fees.

The reality is that very few Canadians realize just how much degradation occurs within their investment portfolios as a result of profits being siphoned out via “management”, “trading”, and “trailer” fees into the hands of financial advisers and the financial institutions that they work for.

The biggest culprit of portfolio degradation is the Canadian mutual fund industry itself. Mutual funds became popular in the ’60s and ’70s as investors realized that they could access and tap into professional portfolio managers via a pooled set of funds.

Admittedly, the concept was a good one. The problem today is that financial institutions have bastardized the concept. Thanks to the large fees attached to most mutual funds, investors are almost guaranteed to underperform the market, while bearing most of the downside risk. Meanwhile, the mutual fund companies rake in their profits regardless.

Mutual funds are not the only ones offering fees that are out of proportion to the value of services received.

Many high nets worth investors turn to professional investment managers for tailor-made, customized investment solutions. Under this scenario, investors will often pay an investment fee to the firm. One immediate tax advantage that private wealth firms have over mutual funds is that investment management fees are tax-deductible whereas mutual fund management fees are not. The “tax-deductible” feature enables high net worth individuals who use portfolio managers, to presumably get better quality and service at lower costs.

These are difficult times for private wealth management firms, more so with the larger ones, as they have high operating costs and large overhead to maintain. A sharp depreciation in the value of portfolios and migration of assets from high-margin products to the safety of deposits, money market products, and government bonds, has eroded profits for many of these large firms.

Leave it to the financial services industry though to figure out innovative ways to disguise higher fee structures and market ill-conceived products.

At many large firms, an incentive exists for wealth managers to churn accounts to generate trading fees and commissions. These commissions often serve as a drag on the portfolio and directly convert client principal into fees and commissions for the broker and firm.

Higher trading commissions are often overlooked and downplayed by private wealth firms as simply small, immaterial costs within a ‘Buy and Hold’ portfolio. Make no mistake, high trading fees eat into profits over the long run. Furthermore, it compels portfolio managers to take a “Buy and Hold” philosophy even if the situation does not call for it. It is difficult enough for a portfolio manager to slim positions when the market is in free fall, but it’s that much tougher of a decision if he knows that the account will be further eroded by trading fees. Thus, clients are often left holding the bag much longer on poor performing stocks.

“Proprietary” or “Structured” products have become the next step in the evolution of financial offerings. Most of these are marketed by large financial institutions under the veil that an investor can somehow get the best of all worlds. In truth, these products represent one more way for financial institutions to surreptitiously filter money out of the hands of investors and into their pockets.

The Globe and Mail (“Why Investors Can’t Have It Both Ways” By John Heinzl) recently exposed one such structure product marketed by the Bank Of Montreal, called the BMO Blue Chip GIC. The bank marketed the GIC as a low-risk investment with the potential for large rewards — basically, a “too good to be true” offer. In fact, by the time, you go through all the fine print, an investor, in all likelihood is guaranteed to generate very low returns. The probability of there being some significant upside was highly remote yet the marketing materials focused on the absolute best-case scenario.

Structured products have become so bad that the Securities Exchange Committee (SEC) in the U.S. has launched an investigation into financial institutions that have overcharged individual investors for structured notes while failing to disclose fees, and potential conflicts of interest.