Mutual Funds

One of the more disreputable episodes in the history of online brokers in Canada is finally close to an end.

Brokers got themselves hooked years ago on selling mutual funds that paid them fees they weren’t technically entitled to receive. Quitting these funds has proven to be quite the challenge for brokers, even though they were told 18 months ago to be fully out of this line of business by June 1.

To keep the process on track, regulators announced a plan last week that should result in a clear win for investors holding funds at an online broker. Most of these funds’ assets will be moved automatically and at no cost to much cheaper versions of the same or a similar product, with no tax implications.

By definition, online brokers execute trades for clients and provide no advice about the suitability of investments. Yet brokers long allowed clients to buy mutual funds with fees that included trailing commissions to compensate the seller for advice and service to investors.

The market intelligence firm Investor Economics says $41-billion in mutual fund assets were held with online brokers at the end of last year, a small percentage of the overall total. Over past decades, trailers had the potential to generate billions of dollars in revenue for brokers.

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Brokers have been in touch with clients in recent months about the new regulatory requirements and by now should have stopped selling funds with trailing commissions. But there’s still a lot of confusion about what lies ahead for investors. Here are some need-to-know points based on information provided by regulators and brokers:

The funds investors need to be concerned about for the most part are Series A, B and D

Series A and B are traditional mutual funds with full trailing commissions, while Series D was created for do-it-yourself investors and contains only a small trailing commission. Regulators are insisting brokerage clients be moved to funds versions that have zero trailers, so Series D is out.

The fund industry’s Series F has no trailers, but it has not previously been available to DIY investors for the most part. The market for Series F is investment advisers who are compensated through fees set as a percentage of account assets. Online brokerage clients may be transferred into Series F funds, or a fund company may create a new fund series to accommodate these investors.

Are any funds not covered by the new rules?

Funds that already pay zero trailers are unaffected. Examples are funds from Mawer Investment Management, Leith Wheeler Investment Counsel and Steadyhand Investment Funds.

What investors need to do:

Nothing. Brokers and fund companies are working on an automatic switch of your affected funds into a version of the same product that has no trailing commission, or something very similar. Regulators call these “like to like” or “like to similar” transfers. Expect these transactions to be done at no cost to the investor, and to generate trade confirmations or notifications that can be used to document the details of the transaction.

One thing to note about these transfers is that the fund investors end up in might differ from their original funds in features such as distribution amount or frequency.

Are there exceptions?

It’s possible that a fund company for some reason cannot offer a suitable alternative to a fund with a trailing commission. If that happens, regulators will allow investors to continue holding the fund with a trailer as long as either the fund company or broker rebates the trailer to the investor on a continuing basis. This measure will be in place until Nov. 30, 2023, after which it will be reviewed.

Tax implications in non-registered accounts:

In defining like-to-like and like-to-similar, a regulatory notice stipulates that “there are no tax consequences for effecting such switch.” Regulators made a priority of working toward a solution that would not force investors to redeem funds, potentially creating taxable capital gains in non-registered accounts.

Denied trailing commissions by regulators, some online brokers have introduced commissions on the purchase of mutual funds. For example, RBC Direct Investing now charges 1 per cent of the gross trade amount to a maximum of $50 for buys and switches (no charge to sell), while CIBC Investor’s Edge charges $6.95 for buy and sell transactions and Questrade charges $9.95 per buy and sell.

Brokers that said this week they do not charge commissions on mutual funds are BMO InvestorLine, CI Direct Trading, HSBC Direct Investing, National Bank Direct Brokerage and TD Direct Investing. Desjardins Online Brokerage, Qtrade Direct Investing and Scotia iTrade said they are reviewing their fund commission schedule.

Even with buy and sell commissions, mutual funds become a more intriguing investment option for clients of online brokers after June 1. The knock on funds is that their fees keep them from delivering returns comparable on a consistent basis with what you can get from low-cost exchange-traded funds or index mutual funds that replicate returns of the big stock and bond indexes.

An equity or balanced fund might have a trailing commission that accounts for a full percentage point of its management expense ratio, which is how you document the cost of owning mutual funds. In a fund with no trailer, that percentage point is more or less added to investor returns.

Another win for investors under the new rules is an expanded selection of funds at some brokers. For example, RBC Direct Investing says it will now offer Mawer and Leith Wheeler funds for sale; previously, these zero-trailer funds were unavailable to clients.

At least two investor class-action lawsuits have targeted online brokerages in connection with the sale of mutual funds with trailing commissions. Full disclosure on these commissions is found in the easy to read Fund Facts documents that fund companies publish for all their products.