Registrants that consider recommending DSC funds to clients will have more compliance hurdles to face
Despite much criticism from investor advocates, the sale of deferred-sales-charge (DSC) mutual funds is not prohibited under Canada’s current regulatory regime. However, with the introduction of client-focused reforms (CFR), selling such products certainly will not be easy.
“Under new CFR rules, registrants are required to (a) address material conflicts-of-interest in the best interest of the client, (b) put the client’s interest first when making a suitability determination,” said a new primer from investor advocacy group Kenmar Associates.
The document stressed explicit requirements relating to registrants’ KYP obligations with regards to securities they purchase, sell, or recommend to a product. That includes understanding the impact of “initial and ongoing costs associated with acquiring and holding each security.”
Professional salespersons are also expected to divulge material facts related to fund series conflicts of interests to clients. This includes advising the client when a fund has different series with the same underlying investments; how differences in sales charges and other fees can impact a client’s investment returns; and when a salesperson may have an interest in the choice of fund series that may conflict with the interest of their clients.
“Under CFR, the presence of embedded commissions is considered a material conflict that has to be resolved in the client’s best interest,” the document said.
Despite some arguing that DSCs can help clients from selling in a panic during market downturns, Kenmar noted that there is no published independent research to support that. The DSC schedule, the document argued further, could deter other prudent decisions such as investing in lower-cost, superior funds or paying down debt.
“It is the obligation of the salesperson to educate clients and use professional judgement to advise them during turbulent times,” the document noted.
The DSC model also creates a situation where the dealing firm, the salesperson, and possibly even the branch manager’s interests run counter to the client’s. That means unless the client’s best interests are demonstrably put first through the sale of a DSC fund, such a transaction should be avoided. And while a DSC mutual fund and a front-load series of the same fund may have the same MER, a salesperson must still consider the non-DSC alternative for recommendation as the prevailing front load is effectively 0%.
“The salesperson also has to look at comparable funds that are lower MER (no load/non- DSC) and recommend the one that is in the client’s best interests,” Kenmar stressed.
On the KYC side, the document stressed the need for comprehensive and fresh information, with updates required every three years at a minimum. Salespersons should consider the personal financial circumstances of their clients when making investment recommendations. Aside from the existence of ongoing debt, they should also bear in mind issues of liquidity, as well as the client’s desire to take on risk, investment time horizon, and ability to absorb losses — all of which are crucial concerns for seniors and those facing health challenges.
“The use of leveraging with DSC funds places clients in an unconscionable high risk situation,” the guide stressed. Aside from establishing the client’s desire to take on risk, those recommending a leveraged strategy with DSC funds should address their capacity to absorb losses and whether they actually need to use leverage. “A responsible CFR suitability analysis is highly unlikely to justify such a risky portfolio construction and investing strategy.”
Even in cases where a DSC fund recommendation passes all the suitability screens mentioned previously, registrants should be compelled to consider low-load DSC funds with shorter hold periods.
“It is hard to imagine a scenario where, for retail investors, having a 6-year redemption schedule is better than a 2-year one,” the guide said.
