Commission-Based Mututal Funds vs Fee-Based Compensation by The Brondesbury Group
The Ontario Securities Commission (“OSC”), acting on behalf of the Canadian Securities Administrators (“CSA”) commissioned The Brondesbury Group (“TBG”) to review existing research on mutual funds compensation. The objective of the literature review is “…to evaluate the extent, if any, to which …The use of fee-based versus commission-based compensation changes the nature of advice and investment outcomes over the long term” (RFP, OSC 201314M-93, page 1). By commission-based compensation, we mean transaction-based compensation (various sales loads paid under front end and deferred sales charge arrangements) and asset-based compensation paid by the product provider to the advisor’s firm such as trailer fees in Canada and 12b-1 fees in the US.
Using respected sources of research on securities markets, the aim of this research is to determine how the nature of compensation materially affects investor outcomes, when all other things are equal. In addition to reviewing the relevant literature and other associated evidence, we also reviewed changes in compensation structure in other jurisdictions, focusing primarily on the impact of such changes.
In order to achieve the overall objective of the study, the research needed to satisfy three sub-objectives to the extent possible.
- Identify whether the evidence on the impact of compensation is conclusive enough to serve as a basis for policy formation;
- Assess the weight of the evidence and formulate conclusions about its meaning, potentially including the conclusion that there is insufficient evidence to form a balanced conclusion; and
- Identify gaps in the research that would improve policy formulation regarding compensation practices.
It is important to state what the research will not do.
- It will not advocate a policy, but rather it will summarize and interpret the evidence in a balanced manner.
- It will not weigh in on the topic of the value of advisors.
- It will not report on papers that are ostensibly research, but are in fact nothing more than opinion.
1. Identify whether the evidence on the impact of compensation is conclusive enough to serve as a basis for policy formation
Evidence on the impact of compensation is conclusive enough to justify the development of new compensation policies. All forms of compensation affect advice and outcomes. There is conclusive evidence that commission-based compensation creates problems that must be addressed. Fee-based compensation is likely a better alternative, but there is not enough evidence to state with certainty that it will lead to better long-term outcomes for investors.
Evidence from academic research is sufficient to form several clear conclusions about investor impacts of compensation.
- Funds that pay commission underperform. Returns are lower than funds that don’t pay commission whether looking at raw, risk-adjusted or after-fee returns.
- Mutual fund distribution costs raise expenses and lower investment returns.
- Advisors push investors into riskier funds.
- Investors cannot easily assess what form of compensation is best for them and readily make sub-optimal choices.
Academic research also shows several important facets of advisor behavior related to compensation.
- Compensation influences the flow of money into mutual funds. Higher embedded commissions stimulate sales.
- Advisor recommendations are sometimes biased in favour of alternatives that generate more commission for the advisor.
- Commission is only one form of inducement that influences sales. Other inducements (e.g., advancement, recognition, etc.) can also influence sales.
- Compensation affects the effort made by advisors to overcome investor behavioral biases, including biases that may lead to sub-optimal returns.
Where regulation has been changed to ban or limit commission, there is evidence that this change impacted investor outcomes.
- In the absence of embedded compensation, advisors recommend lower cost products. These typically have better returns because of lower expenses.
- While removing commission lowers product cost, advisory fees may rise as a means of paying for the cost of service. There may also be new or increased administrative fees, higher costs on margin accounts and lower payments on cash balances.
- It is not yet clear whether moving from commission-based to asset-based compensation will result in a net improvement in the overall return to the investor.
2. Assess the weight of the evidence and formulate conclusions about its meaning
Based on the research cited, we can formulate some high level conclusions that are backed by substantial evidence. In addition to compensation, we identify some related issues that affect investor outcomes.
- Investors are easily confused about charges. To the extent that legacy commission-based compensation persists alongside asset-based fees, confusion is likely to continue. New fees and charges (e.g., administration, paper-based reporting, etc.) can deepen the confusion.
- Investor behavioral biases are unlikely to be overcome as a result of changing compensation schemes alone; although it is possible they can be moderated.
- In jurisdictions that have moved to fee-based compensation, people with less wealth and less income find it harder to get advisory service than others. We do not know whether it is more difficult with fee-based compensation than it was before the change in compensation regime. Alternative advisor methods (e.g., robo-advisors) are developing to fill the advisory gap.
- Mis-selling of investments based on improper match between risk propensity and the risk of the investment will not be eradicated by a change of compensation regime, but it will likely be diminished.
3. Identify gaps in the research that would improve policy formulation regarding compensation practices
There are a number of important questions that existing research does not answer which bear on the impact of compensation. We focus on four areas of research below.
The ideal study for any number of these would involve comparison of individual clients and advisors over time spans of a few years, with a sample that included clients served through different compensation regimes. The regimes to be compared should include: commission, asset-based, salary, and transaction fee (discount broker). To be effective, any study would also need to consider the income, wealth and sophistication of the client. It should also consider the registration category and experience of the advisor.
With this general approach as a background, the major research questions that would improve policy formulation on compensation include the following.
- Investment returns after all costs: Considering all sources of cost including administrative fees, below market interest paid on free account balances and other relatively subtle costs, how do investment returns differ by compensation regime?
- Product advice: How does product advice differ by compensation regime considering cost, risk, and effect on remediating biases in the investor’s portfolio? To what extent is there evidence of mis-selling in the product advice?
- De-biasing investors: How does compensation relate to the behavioral bias in an investor’s portfolio over time? Is there evidence that some compensation regimes are more likely to de-bias investors? When evidence of de-biasing is absent, what factors deter the advisor and the investor from acting?
- Intangible benefits: What do investors want in addition to money? Do they want peace of mind, time for more economically valuable pursuits, time for more pleasurable pursuits, or just the sense that someone else is looking after their needs? How well do different forms of compensation deliver on these intangibles?
In summary, the evidence on compensation is conclusive enough to serve as a basis for policy formulation. Nonetheless, there are questions about the impact of new compensation schemes and their impacts that need to addressed to ensure that undesirable and unintended outcomes are minimized.
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