Canada

Author: | Published: 3 Oct 1999
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The Canadian retail market for mutual funds topped C$350 billion ($240 billion) this year amid large regulatory change. This change has appeared from a number of directions and has occurred as successful substitute products have diverted a sizable portion of the household wallet from investing in traditional retail mutual funds. These regulatory changes have had the effect of raising compliance standards for mutual fund manufacturers and distributors while seeking to sweep under such regulation substitute products such as life insurance segregated funds and wrap accounts. The following is an overview of the size of the Canadian market, its participants and the barriers to entry for foreign sponsors.

Overview of the Canadian Market

International participants have long played a role in the Canadian wealth management industry despite Canada's relatively small population of approximately 30 million people. Such participants have historically been attracted by the relatively high gross domestic product, but more recently by an ageing population with a healthy savings rate which is devoting a greater percentage of its wealth to financial assets.

Canadians typically hold their financial assets in:

  • pension plans (defined contribution and defined benefit);

  • mutual funds;

  • segregated funds;

  • stocks and bonds; and

  • savings and deposit products

There has been a significant shift in the last decade from saving and deposit products to investment products such as mutual funds. Assets invested in retail mutual funds in Canada have grown from less than C$20 billion in 1987 to over C$350 billion in 1999. Securities distribution in Canada is dominated by the six largest chartered banks through their branch networks and majority ownership of the largest investment dealers. Among international brokerages, only Merrill Lynch has significant retail securities distribution capacity in Canada (approximately 1,400 registered representatives). Mutual fund distribution however is much more broadly based with independent distributors — and, increasingly, mutual fund supermarkets — distributing a significant portion of mutual fund securities. While the penetration rate of mutual funds is the same as in the US (40% of households) the average investment is only half of that seen in the US market.

However, this strong growth rate is expected to slow. Mutual fund assets under management are widely predicted to grow at a compounded 10-12% a year over the next decade as opposed to the 30% a year growth rate seen over the last 12 years.

Participants in the Canadian Market

There are approximately 80 mutual fund complexes with approximately C$355 billion in assets under management as of July 31 1999. The top 10 complexes have 63.8% of assets under management and the top 30 complexes have 96.7% of assets under management. Year-on-year asset growth demonstrates the tiering occurring in the Canadian market. Year-on-year growth in the Canadian market was 8.0% for the industry as a whole.

Of the top 30 mutual fund complexes in Canada, five are foreign controlled. Of these Fidelity (C$22.8 billion) and Templeton (C$20 billion) are the largest. Altamira (TA Associates - C$4.8 billion), AIM GT (C$4.7 billion) and Atlas (Merrill Lynch - C$3.38 billion) are much smaller operations.

Of the remaining 25 complexes in the top 30, 12 are controlled by financial institutions and 13 are independent (9 public, 4 private).

CI Fund Management Ltd (C$9.04 billion, 14th rank) has just completed the acquisition of BPI Financial Corporation (C$4.66 billion, 22nd rank) which will vault it to 10th place by assets under management.

Sale of Foreign Funds in Canada

Securities regulations in the US and Canada, although similar in objective and scope, differ in ways that make it impossible for a mutual fund to qualify for issue in both jurisdictions. These differences have been used to prohibit the cross border trade of mutual funds since 1984. Regulators have relied on a consumer protection rationale to justify the barrier. However, an argument could be advanced that consumer protection could be maintained and the cross border trade of mutual funds allowed if regulators simply acknowledged the adequacy of certain regulation and imposed minimal additional requirements on foreign mutual funds.

From 1932 to 1984 securities of foreign mutual funds could be issued in Canada provided they met with regulatory approval, but in 1984 they were effectively foreclosed from distributing securities in Canada. Before 1984 Canadian securities administrators exercised their discretion to waive certain requirements.

According to a 1969 provincial and federal study, the US share of the Canadian mutual fund market in terms of assets was less than 5% at the end of 1968. All 19 foreign mutual funds qualified for sale in Canada at the time were formed under the laws of the US. This represented approximately 14% of the Canadian market by number. The 1969 Report added that there was likely a substantial volume of sales to Canadians made by mutual funds not qualified for sale in Canada.

The 1969 Report was written in response to the growth of the mutual fund industry and an awareness that "mutual funds were subject to a variety of legislation, most of it not specifically tailored for them and much of it difficult to apply to them". The 1969 Report was written in order to examine the need for, and propose, a mutual fund regulatory regime in Canada.

In 1984 the exercise of the discretion to allow foreign funds to offer in Canada was suspended. There was however little opposition to this action at the time as it had become apparent that the Canadian and US tax structures for mutual funds and their securityholders were quite different.

In the face of these restrictions, foreign fund complexes have adopted one or more of the following methods to enter the Canadian retail mutual fund market:

  • sub-advise Canadian managed funds;

  • buy a Canadian presence;

  • establish stand alone Canadian operations.

Sub-advise Canadian managed funds

This is the path of least resistance because two partners could contract to delegate investment decisionmaking to non-residents while the Canadian manager retained responsibility for that advice. Historically Canadian managers reviewed, with the help of consultants, the available universe of advisers and then approached such advisers on an unsolicited basis. In 1990 the Ontario Securities Commission (OSC) clarified its view of what constituted advising in the province of Ontario. The OSC stated that it considered a person or a company to be acting as an adviser in Ontario if it, directly or through a third party, acted as an adviser to a mutual fund notwithstanding that the advice to the fund was given to, and received by, the fund outside Ontario. This represented a dramatic expansion of the OSC's purview under its public interest power. At the same time, however, it created the category of non-resident adviser — a registrant that could advise certain types of institutional clients with respect to foreign securities.

Since 1994, however, the OSC has permitted non-resident advisers to register as full-service advisers. This has resulted in a much broader range of clients and permitted activities for a foreign-based adviser.

The big weakness in sub-contracting investment advice is that none of the advantages from strong performance, such as brand awareness, are available to the foreign adviser. In down markets such advisers are always subject to termination under the terms of the agreement; or the inability of the Canadian manager to control the distribution channel.

Buy a Canadian presence

Until recently Canadian complexes were not purchased by foreign buyers because there were not many for sale; and the valuations requested were very high. Generally in Canada there has been a much lower level of merger and acquisition activity in the mutual fund industry than in the US and the UK.

Foreign buyers, absent strategic considerations, should not be able to pay as much as a domestic buyer for a given asset (when one becomes available) because such participants would not enjoy the economics of putting the two businesses together.

With slower growth prospects, valuations of public complexes in Canada have fallen and with them the expectations of private market participants. The big advantage to this option is that one can acquire a sizeable toe-hold in the Canadian market quickly, potentially with a recognized brand and management team. The major disadvantage is the cost to be paid.

Establish Canadian operations

The most involved approach has been for foreign (usually American) mutual fund companies to set up stand-alone operations in Canada. For example, Fidelity and Scudder have established such operations in Canada. However, they are not the same mutual funds that they sell in the US even though their holdings may be identical. For a US company to sell a "mirror" or "clone" fund in Canada they must establish a Canadian subsidiary and qualify for sale a completely new mutual fund for the Canadian market. The new fund may simply be a clone of an equivalent US fund but it will be distributed in accordance with all Canadian securities regulations including investment restrictions, custody and prospectus requirements. Securities of such a fund would not qualify for sale in the US.

Experience has demonstrated that such Canadian funds usually cost as much for retail investors in Canada as typical Canadian mutual funds. This is disappointing to many Canadian investors considering that equivalent US mutual funds are often less expensive than Canadian funds. When a US fund company distributes funds in Canada in this way they have to go through the same costs as any other Canadian mutual fund.

These costs include:

  • incorporating in Canada;

  • having Canadian resident directors;

  • renting office space and staffing offices;

  • preparing and filing a prospectus in a number of Canadian jurisdictions;

  • prepare advertising material in accordance with Canadian law;

  • seeding the fund;

  • meeting Canadian regulatory capital requirements;

  • having insurance;

  • contributing to a contingency trust fund;

  • paying any applicable licence fees;

  • keeping records in accordance with Canadian law;

  • conducting a substantial amount of the fund's administration in Canada;

  • paying a Canadian custodian; and

  • producing documents in both official languages.

Conclusions

A number of factors have conspired in the past 18 months to slow the growth in assets for mutual fund complexes in Canada. Most commentators believe growth rates will be 12% - 14% per year in the coming years and therefore see the current slowdown as an opportunity. International complexes seeking a presence in the small but significant Canadian market can now enter in a number of ways depending on their strategic objectives.


Contact Details

F. David Rounthwaite

Tel: (416) 601 7900

Email: drounthw@mccarthy.ca