CRM2 - Big regulatory changes coming to Canada's mutual fund industry

What Canadian mutual fund investors need to know

CRM2 is short for "Client Relationship Model - Stage 2. Regulators have passed new rules that came into effect July 15, 2013. Some became effective on that date but many will transition over a 3-year period. While CRM2 refers to some changes regarding the sale of other securities, I will restrict this discussion to how CRM2 affects investors who are interested in buying mutual funds, and investors who currently own mutual funds.

Advisor.ca’s summary of the new CRM2 regulations is as follows:

"For example, starting on July 15, 2014, firms will have to provide pre-trade disclosure of charges, and disclose their compensation from debt transactions in trade confirmations; in 2015, enhancements to client statements will be introduced, which will provide position cost information and market value under a set methodology; and, in 2016, firms will have to begin delivering annual reports on charges and other compensation and an annual investment performance report."

A copy of the actual regulation can be found here:

http://www.osc.gov.on.ca/documents/en/Securities-Category3/csa_20130328_31-103_notice-amendments.pdf

The changes have been described by securities lawyers as "complex".

I previously suggested that a new pre-sale disclosure document would be best discussed verbally and in writing; both parties would also be required to sign off on the document. Both parties would have to declare that all regulatory disclosure requirements have been discussed orally, and that the client has both heard and understood what they mean. The client would also have to declare that they have received a copy of the pre-trade disclosure document.

Unfortunately, the new regulation only optionally requires a verbal discussion or written disclosure. I don't think it quite went far enough.

Also, it is unclear as to how frequently this discussion must occur. If you are a new client, you would want to know how the fund works and how much it costs. If you come in next month to add some money to an existing fund, would an adviser still be responsible for going through the same required disclosures?

One of the new requirements is for advisers to disclose their own compensation, including possible future compensation but there is a problem here again. Advisers must divulge their compensation in a pre-sale discussion. However, the new statements required by the new regulations detail the adviser's firm’s compensation. I can assure the reader that the firm's compensation is not my compensation! An adviser receives only a portion of that number. This will very likely cause confusion when the client is mailed an annual summary of the firm's compensation.

The regulator says this will all be good as it will encourage a discussion and dialogue. I do not agree as the information presented to the client could be confusing. If the intent is to have an informed client, firms and advisers will need to clarify the confusion that will invariably follow. Look for lots of extra asterisks on your statement.

The new statements will display original cost or book value. Unfortunately, the regulator did not choose to be consistent with the proposed changes in reporting, and made it optional for the firm to choose one or the other. Book value causes more confusion among clients than anything else. Book value consists of original cost of the investment plus re-invested distributions and possibly other things. Clients almost always mistake book value as their original cost. More asterisks needed.

One of biggest changes that firms must make on their client statements is to provide a personalized rate of return for every account.

This requirement, in my opinion, is nice to have but from a technical viewpoint, will be somewhat nightmarish to implement. It will be costly. Industry wide, I believe it will be tens of millions of dollars or more. Additionally, I have concerns that most of the new ROR calculations will be inaccurate.

For students of the time value of money (I am one of them), a rate of return is a sort of elusive mathematical target. There are many different ways of calculating it and mathematically speaking, it is possible to have two or more different rate of returns for the same investment!

The regulator has decided that money (dollar) weighted rates of return is the new standard. 

As every adviser knows, when an account is transferred because the client is changing advisers, or the adviser is changing firms, the new firm would base all of their reporting on the current market value of the assets which would completely ruin the ROR calculations, even though the client’s portfolio had not changed. Therefore, having a new requirement for ROR calculations is nice in theory but difficult/impossible in practice.

The new pre-trade discussion with your advisor has to involve a discussion on his compensation. On your annual statement, you will see a lot more information about the dealer’s (the adviser's firm) compensation (in dollars), the amount of money coming in and going out of your account, and rates of return. Your dealer’s annual statement will start to look similar to the annual statement that the mutual fund companies have been mailing to clients for many years now. 

There appears to be a big question mark regarding consolidating rates of return. The regulator demands ROR for each separate account but I did not see any guidance about consolidated rate of return calculations.

If a client asks, “How am I doing overall?" I am not sure if we would be allowed to answer that question.

In reviewing the total package of new regulations, I can say that there are some improvements here and there - some good, some not so good.

As to the reasons why all of these new modified regulations - I am not so sure. The CSA wants to establish itself as our national securities regulator despite the Supreme Court of Canada saying otherwise, so the answer might be political. Although I have been always a strong supporter of a national securities regulator, the CSA's first big foray into the mutual fund regulatory world, to me, has been somewhat of a rocky debut. The new rules apply to mutual funds sold by some firms but not all. As a result, many firms will be at a great competitive disadvantage.  Therefore, I do not agree with the CSA’s reasons that Dealers must bear the pain of increased costs, more paperwork, and more complexity while our competitors across the street are exempt.

If you are a financial journalist or investor advocate who demands more regulations one day and then demands lower mutual fund costs the next, who ultimately is going to pay for these millions of dollars of additional costs? We all know the answer - the consumer ultimately pays.

Will the above regulation change the sales process? Yes, it will but only very slightly. Loads, DSC fees, fee-for-service and account charges are currently being disclosed in the pre-transaction discourse with clients, and most advisers already discuss trailers with new clients. Even though trailers are already disclosed in writing within the fund materials (prospectus) given or handed to the client, trailers must now be discussed pre-trade by the adviser. 

Will the new rules change the way an adviser ensures that an investment is suitable and appropriate for a client based on their personal situation? No it won't - we're doing that already.

As I mentioned in my previous article, I suspected that Canada's national regulator would increase the pain of investing and inadvertently discourage investing in general. After reading the new regulations, I believe they are well on the road to do so.

Errata: A sharp-eyed reader has correctly pointed out to me that CRM2 rules do allow for consolidated rate of return calculations but only if the client provides written permission to do so. If we do not have written permission, we presumably would not be allowed to provide consolidated rate of returns.

Additionally, the definition of “account” may need to be clarified as many financial institutions refer to an account in different ways.

A client, for instance, could have a client-name mutual fund account in a plan (like an RRSP, for example), a regular plan, a spousal RRSP, RRIF, etc. In this type of “tier”, the client could have multiple plans within an account.

Most dealers, securities firms, and other financial institutions also have nominee (self-directed) plans. These operate very differently than client-name accounts, which again add some complication regarding the definition of an “account”.