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  6 | INVESTMENT EXECUTIVE NEWS November 2020 Death of independent dealers was greatly exaggerated
However, with the prospect of significant reforms at hand, the fortunes of small dealers may be set to improve.
Ian Russell, president and CEO of the Investment Industry Association of Canada (IIAC), says the investment industry at large is facing renewed fragmen- tation that could see a resurgence in the number of small and mid- size retail dealers.
The expansion of carry- ing broker services at larger independent dealers facilitates the operations of small firms, Russell wrote in a recent col- umn for Investment Executive. And ongoing structural changes within bank-owned firms may push more financial advisors to seek their fortunes in smaller shops.
Perhaps most important, the Canadian investment business faces the prospect of regulatory reforms that could foster the growth of new, independent firms.
The retail investment busi- ness appears to be in relatively good health. Firms’ operating profits have held up this year despite economic turmoil. According to data from the IIAC, profits in the retail segment were up by 25.3% in the second quar- ter compared with the first quar- ter, and net profits rose by more than 40.5% as revenue edged higher and expenses declined.
This resilience comes on the
heels of several years of strong financial results on the retail side of the investment business. In 2018 and 2019, the retail broker- age channel accounted for 18% of overall industry revenue — levels not seen since the years leading up to the global financial crisis — and the channel’s share of overall industry operating profit is back to pre-2008 levels. Between 2016 and 2019, the retail channel’s profits essentially doubled.
Over this same period, the retail channel’s head count continued to grow, with total employment nearing 15,000 ver- sus less than 12,000 in 2016. Most of that employment growth is at introducing brokers.
Against this backdrop, the investment business is facing initiatives that seek to rein in compliance costs and foster com- petition — objectives that should create a more fertile environment for new firms, as compliance burdens tend to fall more heavily on them.
A 2018 study from the Federal Reserve Bank of St. Louis exam- ined the effects of scale on com- pliance costs, concluding that there are significant economies of scale available in compli- ance. While the study looked at banks rather than at brokerage firms, it found that compliance costs at banks as a proportion of overall expenses were about double for smaller firms com- pared with larger institutions. Regulatory reforms that aim to
reduce compliance costs benefit smaller firms the most, the study concluded.
For the Canadian investment industry, one reform opportun- ity is to overhaul self-regulatory organizations (SROs). The con- sultation period for the Canadian Securities Administrators’ (CSA) review of the SRO structure closed on Oct. 23.
While substantive changes to that structure is likely to take some time, SRO reform could signifi- cantly alter the operating environ- ment in the investment industry, particularly for small firms.
For example, the Investment Industry Regulatory Organ- ization of Canada (IIROC) esti- mates that a merger with the Mutual Fund Dealers Association of Canada (MFDA) would generate in excess of $500 million in bene- fits over 10 years.
An analysis of IIROC’s pro- posals conducted by Deloitte LLP estimates that while the bulk of the savings would flow to the large dual-platform dealers that dominate the industry, small firms collectively would enjoy tens of millions in cost savings as a result of an IIROC/MFDA mer- ger, and mid-size firms would see around $100 million in savings.
According to Deloitte’s report, the projected benefits of SRO consolidation would come from savings on systems and technol- ogy, staffing and other admin- istrative costs. The predicted savings, along with an end to the
bifurcation between investment dealers and fund dealers would, in turn, create an easier path for new firms entering the business.
The CSA may favour a IIROC/ MFDA merger or the CSA may have a broader overhaul of self-regulation in mind. Such an overhaul could break down barriers for portfolio managers and exempt-market dealers in addition to the regulatory walls between fund dealers and invest- ment dealers.
Either way, the purpose of examining the SRO landscape is to address an array of concerns, including duplication and ineffi- ciencies in the existing system. Assuming policy-makers fol- low through with reforms, the regulatory environment should become more hospitable to new firms and to increased industry innovation.
The SRO review is taking place alongside the work of the Ontario Capital Markets Modernization Taskforce. The task force is slated to produce its final recommenda- tions by the end of the year, and is contemplating changes such as prohibiting banks from bund- ling their lending and capital- markets businesses, which cur- rently drives investment busi- ness to bank-owned dealers
at the expense of independent firms. The task force also is con- sidering requiring bank-owned dealers to open their product shelves to independent invest- ment products and mandating the use of “open data” in the securities industry to facilitate fintech innovation.
In addition, the task force is calling for a single SRO.
At the same time, the Ontario Securities Commission (OSC) has made several changes to regulatory requirements and to its own operations as part of its burden-reduction initia- tive, which should curb costs for dealers.
The OSC’s changes include streamlining compliance reviews, allowing for more flex- ible oversight arrangements and providing firms with eas- ier access to information. These measures aim to ease some of the bureaucratic hassles that come with operating an investment dealer and should help small dealers the most.
Reports of the death of the independent investment dealer may have been greatly exagger- ated. If policy-makers deliver on promised reforms, independent dealers may soon be staging a comeback. IE
Reforms to reduce compliance costs benefit small firms the most
    HNW clients are confident about finding “superior” investments
Adriana Robertson, head of research and policy at the University of Toronto’s Capital Markets Institute — provides rare empirical insight into the investing attitudes of the wealthy.
The research, published in October by the U.S. National Bureau of Economic Research (NBER), examines what drives investors’ decisions. The paper notes that it’s not possible to run controlled experiments in this area, and efforts to deduce investor motives from financial data typically don’t reveal clear explanations for the decisions investors make.
Instead, Choi and Robertson asked high-net-worth (HNW) investors directly about the beliefs and motivations behind their investment decisions.
The study examined almost 2,500 American investors who held at least US$1 million in financial assets (not including real estate holdings or business assets) each. Eighteen per cent of the survey participants had US$5 million in financial assets and 4% had more than US$10 million.
On average, the survey partici- pants held 53.3% of their assets in equities, 15.4% in bonds and slightly more than 20% in “near- cash” assets (11.1% in actual cash and 9% in term deposits and/or money market funds). Average allocations to other asset classes
— including real estate, struc- tured products and financial instruments such as futures and options — were smaller.
The research found that the top factor in determining HNW investors’ allocations to equi- ties are the recommendations they receive from their invest- ment advisors, followed by time horizon, personal investing experience and the prospect of macroeconomic and personal health risks. The lowest-rated factors include fear of mar- ket losses; advice from friends, family or the media; and a desire to get richer than others.
Wealthy investors also said they aren’t motivated by con- ventional wisdom when it comes to equities allocations. For instance, few reported that their allocation decisions were driven by “rules of thumb” about portfolio mix and diversification, such as the 60/40 rule.
In a separate study, Choi and Robertson found a significantly different set of motivations for typical investors’ equities allo- cations. The researchers asked investors in more typical house- holds some of the same ques- tions, using a sample of more
than 1,000 Americans.
That research paper, pub-
lished by the Journal of Finance in February, found that the general population’s top factors for deter- mining equities holdings are time until retirement, the prospect of health-care expenses, the need for cash to cover routine house- hold expenses, the risk of losing a job and macroeconomic risk: “The typical household’s asset allocation is much more driven by discomfort with the mar- ket, financial constraints, and human capital considerations.”
In addition, typical investors’ lack of trust in the investment industry and lack of investing knowledge are important deter- minants of asset allocation, the research found. For the general population, professional invest- ment advice was far down the list of factors determining equities allocations, ranking 23rd.
Not only do HNW investors rely much more on professional advice to steer their investing decisions, they also appear to have a high level of confidence in their ability to pick winners, the NBER paper states.
“Many wealthy investors believe that they can identify
superior investment opportun- ities,” that paper states.
For example, the research found that HNW investors who choose active investment management strategies do so pri- marily because they expect these strategies to deliver higher returns than a passive strategy would. HNW investors also are confident they can identify active money managers capable of outperform- ance. The research found that 42% of wealthy investors believe that a fund portfolio manager beating the market in the past indicates that the manager has superior stock-picking abilities.
“Overall, the pattern of responses suggests that a signifi- cant amount of active investing through funds by the wealthy is driven by [wealthy inves- tors’] belief that they can iden- tify managers who will deliver superior unconditional average returns,” the paper states.
Further evidence that HNW investors believe they can beat the market includes the fact that almost half of the investors with concentrated portfolios — in which at least 10% of an invest- or’s net worth is invested in a sin- gle stock — said they believe a particular stock will outperform the market; therefore, they do not need a more diversified portfolio.
“The belief that the concen- trated position is a superior investment seems to be the pre- dominant motive for forgoing
diversification,” the paper states. Other possible explanations for large, concentrated hold- ings of single stocks — such as a desire for shareholder voting power, lock-up agreements and market signalling — were much less popular with HNW investors. In addition, the research found that HNW investors don’t fully believe in the basic axiom that risk and return are positively correlated. When survey par- ticipants were asked about their return expectations for a var- iety of stocks, the paper reports, wealthy investors’ beliefs “about the normal relationship between a stock’s characteristics and its expected returns often do not
match historical experience.” For example, wealthy invest- ors said they expect high-mo- mentum stocks to have both lower returns and higher risk than low-momentum stocks. The only instance in which wealthy investors expected a positive relationship between risk and return was when con- sidering growth versus value stocks: HNW investors expected lower risk and lower returns from
value stocks.
Given that the research is
based on surveys of U.S. investors, Robertson says, she can’t be confi- dent about the extent to which the results would be echoed by HNW investors in Canada. However, her “hunch” is that the results “would be fairly similar.” IE
  Wealthy investors aren’t swayed by conventional wisdom regarding allocations

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