A new report recommends tighter controls for the mutual fund sector
RULES AND REGULATION
A new report recommends tighter controls for the mutual fund sector
For the past three years, Mario Codispoti has been playing the stock market by buying mutual funds. And like thousands of other Canadians, Codispoti, an accountant living in suburban Toronto, has been able to select from a bewildering array of investment funds. In fact, Canadian investors pushed the amount of money invested in domestic mutual funds to $127 billion in 1994, from just $4 billion in 1982. During that period, hundreds of companies have been created to cash in on the enormous popularity of such investment vehicles. There are now more than 800 different mutual funds available in Canada and, according to some observers, that has inevitably led to some dubious industry practices—from knowingly selling flawed products to charging investors hidden service fees. But last week, Glorianne Stromberg, a commissioner of the Canadian Securities Administrators, a national body of provincial securities regulators, issued a report in Toronto that could help to protect consumers like Codispoti by forcing mutual fund companies to adopt national standards and to fully disclose where their money is being invested. “No matter where I went the first question was about investment funds,” said Stromberg. “People didn’t understand them or what fees they had to pay.” Stromberg, who is also a commissioner of the Ontario Securities Commission, began her mutual fund investigation last February, and many of her recommendations could be in place early in 1996. She consulted with provincial securities regulators, leading executives in the mutual fund industry and lobby groups representing the sector. And the overriding theme of her 256-page report, Recommendations for Regulating Investment Funds in Canada, focuses on protecting investors from overly aggressive marketing tactics. To advance that goal, she called for the creation of a national regulatory body by which any firm or individual selling mutual funds would have to be a member. As well, to increase accountability, Stromberg said that mutual fund dealers would have to furnish investors with what she termed a “full disclosure document.” It, in turn, would form part of a prospectus and would be legal and binding in the event of false representation. Said Stromberg: “It’s time for a fresh look at the industry.”
That report is now being analyzed by the heads of the Quebec, Nova Scotia, Ontario and Saskatchewan security commissions respectively. Ed Waitzer, chairman of the Ontario Securities Commission said that many of the proposals could be
adopted in Ontario next spring. He declined, however, to say which of the recommendations would likely be enacted initially. And the immediate reaction in the investment community was also largely positive. Dan Geraci, president of Walwyn Atlas Capital Ltd. of Toronto, a subsidiary of the retail brokerage firm, Midland Walwyn Capital Inc., said the prime concern of the report is protecting investors by giving them more and better information. Said Geraci: “The individual investor needs to know a lot more about what it is he is investing in, and who is managing his money.”
To help Canadian investors to find the right mutual fund, the report also takes aim at how the commissions generated from fund sales are deployed—an issue that has often troubled regulators and consumers alike. Under Stromberg’s plan, all payments to fund companies, except for specific sales commissions detailed in their prospectuses, would be prohibited. That would put an end to so-called soft dollar deals and reciprocal commissions. Under such arrangements, sales commissions that an individual investor pays to purchase a mutual fund are used by the firm selling the fund to buy services, such as research, computer software or other services, from a brokerage firm. But many industry analysts believe that the brokerages can then unduly influence what is being sold by mutual fund salesmen. And that could lead to a conflict of interest Noted Stromberg: “These are unacceptable business practices that raise many questions.”
Among Stromberg’s other key proposals:
• A firm selling mutual funds would be required to have an independent board oversee its investment funds.
• In addition to a national regulatory body, a joint regulatory coordination group should be set up to monitor new industry participants in the sector and to ensure that no regulatory gaps emerge.
• A standardized system for calculating the value of a mutual fund should be developed.
• The industry should adopt a universal set of standards for determining the value of volatile, high-risk financial instruments, such as derivatives, in a portfolio.
Stromberg said the sweeping reforms are necessary because the investment industry has become significantly fragmented. In fact, mutual funds can now be sold by banks, trust and insurance companies, brokerages and financial planners. And each of those institutions, in turn, are regulated by different bodies. Bringing them under a national regulatory system, she said, would streamline the industry and better protect consumers. “One of the problems is that different financial institutions are selling the same type of investment” said Geraci. “But regardless of where you buy your mutual fund, there should be a consistency in the level of disclosure, skill and knowledge.”
Many of the recommendations were supported by representatives of the mutual fund industry. For one, Shirley Babaluk, assistant manager for personal financial services with the Winnipeg-based Investors Group Inc., said that not all salespeople in the industry have
been trained properly. This became apparent last year, she said, when volatility in the stock market forced a large number of investors to abruptly cash in their mutual funds. “Investors weren’t properly aware of all the factors that can affect the value of mutual funds, and they panicked,” said Babaluk. “This is an indication of a requirement for better training [for sales and support staff].” The Investment Dealers Association of Canada, which represents the securities industry, also backed many of Stromberg’s findings. Association president Charles Caty said that his group supports Stromberg’s attempts to create a common regulatory environment across Canada. And he echoed the call for an increased level of disclosure. “There should be clear disclosure about an individual fund’s objectives and risk profiles,” said Caty. “That would permit a consumer to make a better comparison between one fund and another.” like Stromberg, Caty also wants to clean up the controversy surrounding the issue of “soft money.” He said that it is unfair for a consumer to pay commissions on the securities transactions with the mutual fund only to have the firm use those fees to buy services from a broker. Doing so, he said, leaves the impression that the mutual fund sale was based on what the salesman’s firm needed, and not what the client required. “It doesn’t look good or smell good,” said Caty. “It would be cleaner if none of that was allowed.”
Still, Stromberg’s proposals received a less enthusiastic reception from Thomas Hockin, president of the Investment Funds Institute of Canada, a group representing the mutual fund industry. He said Stromberg’s report was merely a discussion paper and represented only her view. But he did agree with Stromberg’s suggestion that the Canadian public wants a national regulatory body to oversee the industry. Such a board, he said, should be self-regulatory and comprised of representatives from the companies that sell mutual funds in Canada. And he also agreed with the report’s suggestion that investors would be protected by a higher degree of disclosure. Said Hockin: ‘We did focus groups, and investors were saying they wanted one or two pages of the core things that they need to know from a risk point of view.”
While attempting to tighten the regulations surrounding the industry, Stromberg also proposed to sharply expand the sector by allowing banks to sell mutual funds on behalf of other investment firms. By doing so, the industry would have access to the banks’ vast network of customers. Added Geraci: “It will be a boon for those funds which are selected by the bank and level the playing field for investors.” And a level playing field is something that investors—especially in times of market uncertainty—badly need.
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