The Politics Between Brokerages and their Full-Service Financial Advisors

The following is an excerpt from the recent edition of our firm's Investor Awareness Kit:

When a full-service financial advisor starts off at a full-service brokerage, they are given a starting salary for the first year only. Then, exclusively, they earn only on commissions. An advisor has a great deal of discretion to charge however they like. Whether they've been in the business for 26 months or 26 years...whether they've barely passed their licensing exams or hold a series of professional designations...It is up to them to decide how much they will charge their clients. What they don't have control over, however, is what percentage of the commission charged they will keep. That goes to the grid. Basically, the more commissions an advisor earns off his 'book' (the term used for all an advisor's clients), the higher percentage of their commissions the advisor gets to keep. For example, an advisor in his first few years of business will have fewer clients and therefore will be lower on the grid (take a lower percentage of commissions charged) then say somebody who has been in the business for years.

The grid, which varies from brokerage to brokerage, indicates the proportion of the commission that goes to the advisor versus the brokerage. The dynamics of the relationship between broker and brokerage is more like a partnership. The brokerage's responsibility is to provide the office, the assistant, the research, additional support and overhead, while the broker's responsibility is to provide the clients.

Keeping this partnership concept in mind, it must be noted that an investment advisor is more accurately running their own business. They are given a great deal of flexibility of what they can do with their clients, and they are fairly independent. The point is there can be great investment advisors at a specific brokerage firm, and there can be some not so great investment advisors. What's more important is that their value to the firm is assessed not by the success of their advice, but by the amount in commission being charged to their clients and going to the grid. An advisor on their brokerage's Presidents Club or Executive Club, being dubbed a Senior, Director or Vice President; are given these distinctions on account of this.

The difference between an Investment Policy Statement and a Know - Your - Client Form

All this jabbering about the importance of having an Investment Policy Statement, and I forgot to mention an important dynamic already in place in the industry. An IPS is not to be confused with a Know Your Client form, which are designed to protect and limit liability of the brokerages. While the IPS is an extensive document outlining the vital dynamics of the client-broker relationship, the know-your-client form represents the industry's minimum standard of what is expected for an advisor to know about their client. For example, the Mutual Fund Dealers Association requires the following:

- Investment Knowledge: extensive, moderate, none
- Risk tolerance: low, medium, high
- Time Horizon: 1 to 3, 4 to 5, 6 to 9, 10 plus
- Investment Objective: income, growth (short/long term), balanced
- Individual income
- Household net worth

Note how general a profile this is. If you are ever a victim of advisor malfeasance, it is the first thing that is looked at by the Branch Manager or perhaps the Compliance Department. Furthermore, John Lawrence Reynolds wrote in his book, The Naked Investor, that financial advisors will have their clients sign the bottom and fill the rest in later. Be wary of this because, if there is problem, it will be the place you'll have to turn to in order to make your case.

The Importance of having an Investment Policy Statement

If there's one thing that we hammer home with our clients, it's the necessity of an Investment Policy Statement prior to beginning your relationship with your financial advisor. If you don't have one, have your advisor set one up for you. If you do have one, verify that it's complete. In his book The Professional Financial Advisor, John DeGoey put forth the statistic that 15% of retail investors with financial advisors have investment policy statements. Although it has been six years since the book came out and, surely, the percentage has increased significantly since then, it is quite an issue.

An Investment Policy Statement (IPS) is a document that details the dynamics of a client's relationship with their financial advisor, such as the most vital elements of a portfolio's elements and design. It is the ultimate guide to transparency between an advisor and the client. Having an Investment Policy Statement, quite frankly, makes the client's expectations clear, and the advisor will understand fully the standard he or she is being held to. The more a client knows entering a relationship with a financial advisor, the healthier that relationship will be.

The best breakdown that could be found of what should be in the Investment Policy Statement (this includes the industry textbooks) was in Warren Mackenzie's The Unbiased Investor. Great book pick it up, if you have a chance!

An IPS should have:
i) the target average rate of return for this investment portfolio over different time periods.
ii) The expected range of returns for the portfolio as a whole over different time periods.
iii) The percentage of each asset class in the recommended portfolio and the permissible ranges for each asset class.
iv) The benchmark that will be used to evaluate actual performance (see next page).
v) Possible investment constraints
vi) Rebalancing strategy
vii) All fees that will be charged
viii) Frequency of contact
ix) Topics to be covered in the quarterly review meetings.
x) Assumptions being made

Eenie.... Meenie..... Mynie.... Moe (How does an advisor pick their mutual fund firms).

The mutual fund industry is quite saturated with there being an array of different types of mutual funds, which might specialize in a specific sector, geographic location and/or asset class. Financial advisors, who choose to invest their clients in mutual funds, have a huge selection to choose from. As most mutual fund firms carry a wide selection of mutual funds, a financial advisor will typically only use the investment products of a few firms that he or she is comfortable with.


How do they choose which mutual fund firms to put their clients in? In order to get financial advisors to carry their investment products, mutual fund firms employ "wholesalers," whose job it is to persuade advisors to understand why their funds are better than the rest of the industry. Historically, "wholesalers" used what was called "soft dollars" to entice advisors to carry their products. These incentives could have been tickets to shows, games or even all-expense paid trips. As of late, these widespread "bribes" have gotten under control and have declined significantly over the years. However, they do still exist, but in a much toned down manner. Furthermore, a mutual fund firm can also offer higher trailer fees as an incentive to get advisors to carry their funds.


Looking at past performance does show a track record but do keep in mind that it is common place for mutual fund firms to merge bad funds with decent ones to make their history look better...Yes, this is permitted...and, yes, the next thing to wonder is how do we know how legitimate their posted returns are.

Deciphering Churning

Young and dashing...the young man looked every bit the Bay Street executive. A beautiful wife and home...he exuded a Canadian success story. Little did many know at that time that they were dealing with Bay Street's most notorious con man later made infamous in John Lawrence Reynolds' Free Rider: How a Bay Street Whiz Kid Stole and Spent $20 million. In just a few years, he manhandled his clients' accounts under the noses of his brokerages, who gave him plump titles and credibility. Smooth talking and charismatic, Michael Holoday was considered the ideal investment advisor by his clients until it all came crashing down. Holoday's favorite vehicle for his malfeasance was churning.

Churning, in the retail investment industry, is excessive trading in a client's account done with the intention of generating as much commissions for the advisor, while not focussing on the client's needs.

First and foremost, I'm grateful to say that the retail investment industry has improved to a point where instances of churning are becoming significantly less prevalent. Historically, the retail investment industry was filled with entirely commission (transaction)-based advisors where a commission was charged every time an investment product was bought or sold by a client. These commissions were the advisor's sole medium of receiving compensation, and they depended on it for their livelihood. Hmmm...I just realized I was talking in the past tense. Commission-based advisors still exist today and, most of them are honest and hard-working people. It is the industry, which they've adopted as their own.


Churning is rarely the reason for a clients' complaint. Usually, they complain about another aspect of their portfolio, such as losses, when churning is discovered. The problem was more common with commission-based advisors, whose drive for revenue may have interrupted their focus to give their clients the best.

A general way to assess churning: Add up the value of all purchases and sales (excluding Treasury Bills) in a year and divide the total by the value of your account in the beginning of the year. This is called turnover. If your turnover is less than 2, you are fine. If your answer is between 2 and 6, you should be conscious and start asking questions regarding the frequency of the buying and selling. Do be aware that the older you are, the closer to 2 you should be.
A more conservative method measurement of churning includes only the cost of purchases and not the cost of sales. If the answer is over 6 in this method, give your branch manager a call.

The Power of the People

Can consumer advocacy become a powerful special interest group? I certainly hope so. One of my favorite consumer advocates, Ellen Roseman, is one of the country's few unwavering constants. With a blog and a column in the Toronto Star, she cunningly points out injustices being committed toward the consumer. While for the most part it is teaspoons out of an ocean, she builds awareness on whatever issue, and we're all better for it, including the companies she outs.

Now, Canadians have long been the victim of higher prices. With a relatively small population and oligopolies galore, we only have a few wireless companies to choose from, a few phone companies, a few Internet providers....and wait, it's provided by all the same companies. Of course, such variables do put us in the position for higher prices compared to other consumers worldwide, and we, for the most part, have accepted it. Sure, we complain. But, more so as a conversation piece, not so different from talk of the weather or celebrity gossip. Rarely, has such a statement been proven wrong until recently.

When Rogers won the license to carry the Apple's IPhone, die-hard fans held their collective breaths. If a Canadian wanted an iPhone, they'd have little choice but to accept the fees charged. The fee schedules did finally come out and provoked wide-scale uproar. All of a sudden, Canadians, who had been the victim of higher prices for years, were furious. Passive Canadians, who had accepted their fate of higher cell phone plans, higher gas prices in an oil rich country and a number of other things, were all of a sudden in a fury. Why? Why now? Of course there can be several answers to this, but when people want what they cannot afford....

Most famously, a site (http://www.ruinediphone.com/) was set up with the intention of showing Rogers the frustration felt by Canadians. With over 60,000 people signing the petition, the fervour fuelled countless newspaper articles and negative publicity for Rogers and, by extension, Apple. Reading this commentary myself, I thought Rogers would simply yawn at the headlines, ignore the petition and life would continue. They did have exclusive control over the Apple iPhone.

Shockingly, they yielded. They adjusted the price points, and Canadians can now get an Apple iPhone at a value short of a rip-off.

Why do I care? Why am I writing about this? It's sort of this successful change from the grassroots...the bottom-up approach....that exemplifies probably the most untapped way to get change in this society. Why we haven't more efficiently harnessed it remains beyond me. The Leafs are horrible? We question management's commitment? Why...Why, instead of just fan clubs, do we not just have fan unions, which can boycott entire strips of games. For those sports enthusiasts, remember, when MLSE hired Mike Babcock as GM of the Raptors. A novice GM with no prior experience, we watched Vince Carter get traded away for nothing and a decent team reduced to subpar. It wasn't until the fans stopped attending...that people stopped watching...that Babcock was fired, and they decided to get a former Executive of the Year (now, a two-time Executive of the Year), Bryan Colangelo. The Raptors are a good team again.

I do realize it seems like I'm harping and perhaps I am. However, if this approach can be applied to the Apple iPhone, then why can it not be applied to lobbying for lower MERs (Management Expense Ratio) or boycotting Principal Protected Notes and other investment products that sound sexy but provide little value to Canadians. Lobbies that, if done successfully, will save a Canadian family thousands of dollars and make Bay Street conscious of our educated collective.

It cannot go past us that change from the bottom-up is possible in this country, and we have a responsibiliy to ourselves and future generations to adequately harness a power so far neglected.

Dow Jones officially in a bear market

Now, I try to avoid play-by-plays of the markets just because there are so many people who do it much so better than me. However, this is an occasion. The Dow Jones is officially in a bear market, which is characterized by a 20% decline. With the S&P500 and the Nasdaq flirting with a similar classification, there is a great deal of uncertainty in the market right now. Understatement of the century, right?

As the economy goes through an incredibly volatile period and is flirting with stagflation (high inflation, limited growth, high unemployment), it kind of makes me feel...that really...it's about time. It's about time this uncertainty reached the mainstream and played its toll on the markets. With high inflation, central banks have no choice but raise rates to keep it in check. However, a recessionary environment is best fought with lowering interest rates. Not since the 1970s have so many brilliant men and women been so doubtful of what the central bank should do. It appears there's no clear answer. With these issues with liquidity (our "credit crisis"), we're learning as we go along.

Remember, although a recession has been declared by many pundits, it has not yet reached a consensus yet. With the second quarter over, companies are beginning to come out with their second quarter earning's numbers. Perhaps with this, we'll be able to assess our two consecutive quarters of declining GDP (and, hence, declare a recession).

Remember, folks, be brave. For every recession, there is a recovery. As retail investors, we have to be concerned with the long-term and not selling on weakness. Hang tight. If you guys have an Investment Policy Statement and a full financial plan, you have all the insight you need going forward. The more transparency in your relationship with your advisor, the more confidence you have in your portfolio during uncertain times.

An alphabet soup of designations!

When assessing a financial advisor's qualifications, most Canadians just don't know where to begin. Besides academic degrees, the plethora of professional designations in the industry tend to make people a little confused. Here is a mini-glossary of some of the more popular ones out there:

CIM: Certified Canadian Investment Manager -- a discretionary portfolio management designation of Canadian Securities Institute.
o Completion of 3 levels (courses), including the Canadian Securities Course.
o Experience Requirement: None

FMA: Financial Management Advisor -- A financial planning designation of the Canadian Securities Institute.
o Completion of 3 levels (courses), including the Canadian Securities Course.
o Experience Requirement: None

DMS: a professional designation of the Canadian Securities Institute specializing in the advanced concepts of derivatives and risk management.
o Completion of 5 levels (courses)
o Experience Requirement: None

FCSI: Fellow of the Canadian Securities Institute -- senior financial services designation *
o One of the above designations is needed (CIM or FMA), a licensing course, an additional course and dedication to continuing education (42 hours per year)
o Experience Requirement: at least 5 years of financial services experience in 8 years.
o Required to complete the Ethics Module and Case Study or the Ethics Seminar

CIMA: Certified Investment Management Analyst -- senior financial services designation *
o Pass 2 levels of exams, as well as maintain an average of 20 hours of Continuing Education per year
o Experience Requirement: 3 or more years of financial management experience


CFA: Chartered Financial Analyst -- the senior designation for investment analysis *
o Pass 3 levels of exams
o Experience Requirement: 4 years of acceptable professional work experience


CFP: Certified Financial Planner -- senior financial planning designation *
o Pass one exam after completing a FPSC approved education program, as well as maintain 30 hours of Continuing Education every year
o Experience Requirement: at least 2 years of personal financial planning related work experience

* Acceptance of these designations requires their holders to abide by certain ethical standards and guidelines set forth by the institution they are accepting it from.

Supreme Court of Canada works their magic...

"It reaffirms what has been the basis of company law in Western Europe and North American for the last 250 years since share-owning corporations came into being: the duty of the directors of the company is only to the shareholders, because they are the owners of the company."
--Gavin Graham, Chief Investment Officer, Guardian Group of Funds.

Now, I wouldn't put this quote forward as an unbiased view, as the Guardian Group of Funds is a mutal fund company owned by the Bank of Montreal. For Mr. Graham to favour the shareholders isn't exactly groundbreaking, but this statement reveals an accurate sentiment of those who favoured the deal.

The Supreme Court of Canada ruled in favour of the $52 billion leveraged takeover of BCE. A ruling against would have killed Canada's largest corporate buyout in its history. The case pitted shareholders against bondholders in the most unprecendented of fashion, and pundits had no idea which way the Supreme Court judges were going to rule. Considering the years that have transpired since such a significant ruling dictating corporate law, their preparation and decisiveness is absolute remarkable. I'd love to go on and on about this, but as the seven justices who ruled have given themselves 6 months to elaborate on the reasons for their decision, the commentary is quite limited in scope. This has left the articles and segments profiling the story basically sticking to the facts. Even pundits strayed from making a prediction on the possible outcome....even when asked to....Pundits? Who would have thought?

After everything is said and done, though, it must not be forgotten that the bondholders had a legitimate argument. The fact that the takeover was leveraged (meaning that the entity buying BCE was taking on debt to complete the buyout) resulted in the value of the bonds being lowered by 18%. BCE will go from an investment grade credit to a private company with junk bond status. Meaning that the people that lent BCE money thinking it was a fairly safe loan, have now totally been sandbagged over a variable they couldn't possibly have foreseen. Their frustration is, as well as should continue to be, understood.

With this in mind, this case isn't only about bondholders versus shareholders, but the legitamacy of the rating agencies passing judgement on these bonds. They blew the call on asset-backed commercial paper, duping investors, and now here we are....again. This wasn't as safe a debt issue as they graded it to be. But then again, there's really no way they could have known. A future blog post really needs to take into consideration the flaws of ratings agencies.

A later musing, perhaps. For now, congrats to the shareholders of BCE and the Ontario Teachers' Pension Plan.....and congrats to the Supreme Court of Canada. All in a day's work, eh.

Tim Russert (1950-2008)

While I was on the phone today, I was hit by shocking news run across my blog feed: Tim Russert had passed away. One of my favorite newsmen, Tim Russert, long-time host of Meet the Press, struck fear across the hearts of even the most seasoned politicians. As much as politicians must have loathed going on his show, they were compelled to because an appearance brought a credibility that no other journalist could match. Now, that's power...something he never abused, as he was tough on each equally. They had to explain themselves. Any contradictions in their views? You bet his viewers would know about it. Republican? Democrat? It didn't matter.

I wrote an obituary (or rather, tried), but as I see the outpouring of support and love for this man...I realize I'm a little out of my league. But I want to say he was a true success: a successful career and a successful family man, which is particularly exemplified with the pride and love he felt toward his son, Luke.

I do want to bring attention to an incredible blog entry I read paying respect to the man. Written by a doctor in Buffalo (Tim Russert's hometown), I feel a need to post the link. I hope you find it as a profound as I did.

http://alirizvisblog.blogspot.com/2008/06/tim-russert-1950-2008.html

Mr. Russert, you will be missed.

Escaping the Deferred Sales Charge

Are you invested in DSC mutual funds? Remember, with DSC funds, commissions aren't charged up-front, but rather redemption fees are inflicted when the client leaves anywhere from o to 6 years after investing in the fund. The earlier you leave, the higher percentage in fees. Is it possible to get out without paying such redemption fees? Yes...

• 10% rule: Most mutual fund companies allow clients to redeem 10% of their holdings each year in a DSC fund or transfer amount into front-end load funds in the same family. This is a viable option, and it serves as beneficial to the advisor as their trailer fee (a fee they receive from the fund company for keeping their client invested with them) doubles for this portion of the portfolio.
• Another means of getting out of a fund is to switch into another fund in the same family. As the DSC clock goes on for 6 or 7 years (the period of which you'll be charged for leaving), make sure they don't reset the clock to zero. This is usually not a problem.

For both these approaches, there is no uniform method that mutual fund firms use. Please read their simplified prospectus for how they approach these rules.

Some clients, who are unaware of the downsides of the DSC, show a great deal of frustration with their advisor for subjecting them unnecessarily to such a compensation method. They....maybe, led to believe....that they are stuck, not just in the fund family, but with the advisor that entered them into such a model. This isn't the case, as the client can switch advisors.

This won't be as beneficial to the advisor accepting the portfolio, assuming there's no attempt to sell you out of DSC funds. With significantly lower trailer fees, they'll be taking a client with little compensation in the beginning. I think that speaks volumes for the advisor, who, by accepting the account, are counting on a long-term relationship. Respect, in my books. However, a client should be careful if a new advisor's suggestion is to sell everything and pay these redemption fees, especially if you haven't been invested in the DSC fund for long. This will more likely benefit the advisor than the client. Be skeptical of such a suggestion.

David Vs. the Deferred Sales Charge....

A deferred sales charge, or rear-end load fund, is a manner of investing in a mutual fund with a transaction-based (or commission-based) advisor in which there is no upfront fees charged but rather fees are charged when leaving the fund. The earlier you leave, the higher percentage that must be paid in redemption fees. "All your money goes to work for you," a financial advisor will say to make this compensation method more appealing.

It is my belief that there are very rare circumstances where it is the optimum fee choice for clients. In fact, I'll go even further and say that it is one of the most commonly abused tools in the retail investment industry. When qualifying advisors for Onus, their manner of approaching this compensation structure is a factor used to judge their practice. Forget recommending it, if they are presenting it as a viable alternative to the front-end load, when, many times, it is clearly not.... It simply is not good financial advice. With the exception of some extenuating circumstances (such as a problem with compulsive gambling or spending), it is not necessary for you to commit your money into an investment for as long as 7 years.

Due to its high upfront fee paid to the advisor from the fund company (as high as 5% for an equity fund), the advisor is being compensated far in advance for a service that hasn't been fully completed yet [funnily enough, the investment industry acknowledges this with trailer fees being cut by half]. It can create an atmosphere for negligence as they have been paid a strong chunk of their fees and penalties inflicted for leaving a fund family is more than enough incentive to get the client to stay. Thus allowing trailer fees to collect for the broker.

As our society gets increasingly more knowledgeable, the Deferred Sales Charge on mutual funds is being used less frequently. Ten years ago, it was a mainstream option used by a great many advisors. Today, to use it extensively does not exactly garner widespread respect.

Is education really education?

When a tree falls in the forest, does it make a sound? With the sensibilities of that question in mind, I ask you: When an individual receives an education, but does not apply it, is it still an education? While the answers to both those questions are a seemingly obvious 'yes,' a credible point can still be made from them.

I discovered an advisor the other day, who had earned the majestic CFA. The Chartered Financial Analyst designation exemplifies a mastery of investment analysis. It brings instant credibility and respect to the holders' ability to analyze stocks and bonds competently. It is a staple for every analyst...or aspiring analyst....as well as hedge and mutual fund managers.

The CFA requires three exams and several years of experience. You don't simply wake up one morning and decide to write a CFA exam. Anyway, I was a little puzzled when this advisor invested his clients exclusively in wrap accounts, a means of empowering a third party to manage an investor's portfolio for a flat quarterly or annual fee. Essentially, it puts the entire portfolio on auto pilot, so the advisor can focus on other dynamics of their clients portfolio (like their clients' financial plan or tax savings, for example).....Well, this is the justified rationale. However, the truth of the matter is that it could just open up time for them to go recruiting other clients or, for that matter, just relax and enjoy life.

The point is that this method of investing removes portfolio management, asset allocation and, more significantly, investment analysis from the advisor's responsibilities, which are very possibly attributes a prospective client looks for in a financial advisor. This CFA he worked so hard to earn is simply there to more adequately sell himself to the client....it seems. A client will obviously be dazzled by an advisor, who holds the same qualifications as a hedge fund manager or investment analyst. After being left wide-eyed at the possibility of some one-on-one analysis of their investments, the client is being put into investment products that are available to a great many advisors. The advisor's CFA education is not being applied.

A pity, in my opinion. What is the point of an education? To apply what you learn, hopefully. To able society to somehow benefit from it. As it should, the CFA does aid this advisor in attracting clients. Unfortunately, in this case, it's not aiding his clients.

The finer things in life

An exhausting weekend!

Saturday marked the 30th wedding anniversary of my Uncle and Aunt, and their kids put together one of the most incredible surprise parties that I think I will ever witness. Not that this has anything to do with this blog or Onus, but it really reinforces the importance of family and friends. When you see such displays of affection, it makes you realize that, among other things, the existence of an Investment Policy Statement or a full financial plan in your relationship with your financial advisor isn't everything.

It sure does help, though.