Cumming’s Report: The Final Nail in the Coffin for Trailing Commissions

Despite an ever-mounting body of evidence, the investment industry has persistently refused to acknowledge that trailing commissions harm investors. Now, that acknowledgment is no longer necessary because of the comprehensive empirical research that Douglas Cumming has completed for the Canadian Securities Administrators.

Cumming, a finance professor at the Schulich School of Business at York University in Toronto, and two colleagues sifted through a decade of data from 43 mutual fund companies that manage two-thirds of fund assets in this country. The three key findings of this research align with what other unbiased sources of information have been saying and what common sense would tell you:

  1. Mutual funds that don’t pay trailing commissions tend to get investment inflows if the funds perform well and lose inflows if they underperform. But it’s a different story for funds that pay trailers. Investment inflows gravitate toward those funds even if they perform poorly for investors.
  2. This gravitational effect increases as funds pay higher trailing commissions.
  3. Where funds are able to attract investment inflows without having to do so through strong performance, their performance worsens. This occurs frequently in funds that pay trailing commissions.

In other words, trailers warp investment flows by letting something other than what’s best for the investor drive sales, and this channels many investors toward suboptimal funds. Trailers also harm investors, and the market as a whole, by facilitating deteriorations in fund performance. These are profoundly serious findings.

At the same time, these findings weren’t unexpected. They align completely with what investor advocates have said for years: that trailing commissions create systemic conflicts of interest; that those conflicts of interest prevent effective price competition; and that they lead to poor consumer outcomes through investors unwittingly paying high costs for compromised product recommendations.

Cumming’s findings also stand as compelling proof that trailing commissions are contrary to the public interest and that they ought to be banned in Canada as they have been in the U.K., Australia and elsewhere. Many thoughtful people in the investment industry will now concede this. Indeed, they’ll go even further because they see the implications.

They understand that competent professional investment advice can’t coexist with fee arrangements known to be harmful to clients. Now that Cumming has shown the harm exists, they understand that continued opposition to banning trailing commissions will make them look avaricious, biased and unprofessional. In effect, from this point onward opposing a ban will make the opponent appear unfit to be an advisor, destroying their entire value proposition.

But some in the investment industry are blind to this. Fearful that a proposed ban on trailing commissions will reduce their income significantly, and not knowing how else to respond, they’ll simply repeat the hollow and shopworn arguments they’ve used all along.

Chief among those is the argument that a ban on trailing commissions will trigger an “advice gap” in which small investors will lose access to investment advice. It is said this will happen because small investors can’t afford to pay for advice. But there are three things wrong with this argument:

(a) It’s self-contradictory — that is, if you also accept what mutual fund companies and their lobbyists claim when they say (as they frequently do) that trailers are really fees for ongoing advice. If that’s so, then small investors currently can and do “afford” payments for advice through the trailing commissions they’re charged. A ban on trailers would simply place those same dollars under investors’ control, thereby letting them determine how much advice they want to purchase and what they’re willing to pay for it.

(b) There’s currently no obligation to provide advice in return for trailing commissions; and there’s no empirical evidence backing up the claim that small accounts currently receive, and thus stand to lose, significant levels of advice. It’s likely they do not.

(c) An advice gap will arise only if the investment industry fails to innovate and develop new ways to serve small investors. But that innovation is already happening. New online and mobile tools allow firms to provide economical hybrid platforms combining do-it-yourself elements with full-service advice where needed. Robo-advisors offer portfolio construction and continuous asset rebalancing at low cost. And this is probably just the leading edge of an innovation wave.

Other jurisdictions’ experiences can be instructive. In the U.K., reforms led a small number of investors to conclude that they didn’t need advice or that the advice wasn’t worth the cost, but most chose to purchase some advice. There’s a minor residual advice gap, but it’s expected to be filled quickly through further innovation. Meanwhile, the reforms have produced a rapid and beneficial drop in the sale of high-cost funds.

For Canada, the evidence is overwhelming and compelling. Canadians and the market are both being harmed by trailing commissions. That should prompt swift action by regulators duty-bound to protect investors and foster fair and efficient markets.

For that action to be decisive and effective, the only real option is to ban trailing commissions — and the investment industry had best get on board with that if fund companies and advisors wish to maintain their credibility.

This article appears as an Inside Track op-ed in the online version of Investment Executive.

November 24, 2015