Changing Dynamics Of Regulation – The Sunset by Sui Generis

Very few industries actually suffer the same fate as the proverbial buggy whip, that is to say extinction. We wanted to lead with that proclamation because the term “disruption” is bandied about so often that one couldn’t be blamed for thinking that various businesses were becoming antiquated at an alarming rate. But the truth is that most do not die, they simply evolve and survive in a form that may only loosely resemble what they used to be. So while industries rarely become extinct the way the buggy whip did, products often do. An easy example would be photography where the digitization of taking pictures sent the likes of Eastman Kodak and Polaroid into bankruptcy. Given that our knowledge of today’s youth is limited to the fact that more often than not they seem to be taking pictures of themselves, we may suggest that the industry is alive and well and more photos are taken now than ever before. Time and technology change industries, often for the better, and unfortunately leave behind certain products and the companies that create them. By now you’re likely asking “where are they going with this?” as we’ve now established that we aren’t going to be writing a requiem for an entire industry but rather a specific product that is being disrupted.

There are few sectors that the team managing Sui Generis Investment Partners will claim to know intimately. We stick to what we know and believe that this is the best way to drive returns for the investors in the Fund, so far so good there. With that in mind both industrials and manufacturing are well represented in our portfolio. We know energy very well; we understand mining at a very respectable level though we aren’t fans of the fact that both industries seem to consume capital at alarming rates. But the sector in which we find investment opportunities on the most consistent basis is perhaps the most obvious as it’s the only industry we’ve ever worked in, that of course is finance. Now before you assume that we’re going to write some bullish defense of our industry over the subsequent pages (because, why would anyone slag their own industry?) we’ll have to cut you off right there and finally get to the point. The investment management business is undergoing seismic changes in Canada, and the product that we believe has already begun spiralling towards obsolescence is the mutual fund.

Changing Dynamics Of Regulation

We hold very firmly the belief that private investors will continue their mass migration towards lower cost exchange traded funds; henceforth referred to as ETF’s for the uninitiated, and you’re now duly warned that we will be throwing around a few acronyms in this note. As well, we believe that this migration process is about to accelerate in Canada, in essence playing catch-up with what has already happened in the United States. The reason as one might expect is money, more specifically too much of it being paid to fund companies and their managers for doing little more than mimicking a particular index. Why invest in a mutual fund whose management expense ratio (the total cost to manage the fund, also known as “MER”) is 2.2% vs. an ETF at 0.40% when both products ostensibly do the same thing? Why then do mutual fund investments in Canada still dwarf ETF’s by 12x? Once again, the reason is money. Investment advisors across the country are routinely paid “trailer” fees by fund companies to distribute their product. A trailer fee is an annual cash payment to the advisor for investing their clients in particular fund and this fee typically runs about 1% annually on equity funds. While to those outside the industry they may look suspiciously like bribes, there is nothing sinister about trailer fees in and of themselves, they’re simply a way for fund companies to win the favor of advisors across the country…by paying them cash. But a paradigm shift is coming to the Canadian brokerage industry via new regulation known as CRM2.

CRM2 introduces new requirements for client statements, charges and compensation disclosure, and performance reporting.  These amendments came into force on July 15th, 2013 and are phased-in over a three year period, with the final phase effective July 15th, 2016. CRM2 focuses on the trailer fee being paid to the broker and does not disclose in the fee calculation in the MER of the underlying mutual fund.  This has angered many brokers we have interviewed as they feel they are the ones being targeted by the new requirements, not the mutual funds as they were previously lead to believe. The core principal behind the new regulation is to provide the investor with a clear view of what they paid their broker and what they received in return. Both of these numbers are to be represented in real dollar amounts rather than percentages for the first time ever.

So how will these new disclosures change the habits of the brokers?  They’re in a challenging position when being confronted by clients on fees and performance as they have really three choices should they to wish to maintain the client relationship.  1) They can reduce their own fees 2) they can switch money allocated to poorly performing funds into funds with better track records or 3) they can attempt to find lower cost product, or put another way, they will lower the fees of fund companies rather than their own. We believe the importance of this dynamic and the magnitude of the move coming has been grossly underappreciated by analysts who cover the fund companies. Of the choices we just highlighted, option one is a non-starter for a long as possible so you’re left with options two and three, a dynamic that we believe will conspire to irreparably harm the mutual fund companies.

Performance Matters

Now that we’re familiar with the regulatory backdrop we want to focus on performance because now more than ever the investment business is about performance. Imagine the broker pointing out to his client the healthy trailer fee he has been receiving for allocating that client’s capital to a particular mutual fund, then explaining that the fund has underperformed its peers or done no better than the market. It’s an awkward conversation as we believe it will be at this moment that many clients will realize that their brokers are conflicted. Client’s will soon be asking for a fundamental justification and that doesn’t bode well for the asset growth of mutual fund companies, particularly those with poor performance. This leads us to the actionable part of the thesis, identifying the public company whose name should come up more often than any other in the preceding example, CI Financial (CIX-T).

CI Financial is one of the largest asset managers in Canada with an enterprise value of $8.2 billion and a core business that manages $108 billion and the majority of CI’s revenue is earned via fees for the management of mutual funds. These products are distributed through brokers, independent financial planners and insurance advisors.  The value proposition for mutual funds has historically been very simple; provide a pooled wealth management solution that delivers asset appreciation over

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