Embedded commissions should be scrapped in order to better align the interests of the investment industry and investors, enhance competition and foster investment industry innovation, says Morningstar Research Inc. in its submission to the Canadian Securities Administrators (CSA) consultation on the future of embedded commissions.

Specifically, Morningstar says in its submission that embedded commissions should be discontinued because they create a conflict of interest for financial advisors by aligning advisors' interests with asset managers rather than their own clients.

"While clients' best interests are served by holding lower-cost funds, asset managers have an incentive to promote higher-cost alternatives from which they generate more revenue from fees," the Morningstar submission states. "Asset managers use embedded commissions to give advisors incentive to favour higher-cost funds, creating a conflict of interest."

This conflict results in commissions-driven advisors favouring more expensive, actively managed funds over cheaper index funds, the Morningstar submissions states.

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In fact, Morningstar reports that as of March 31, index funds accounted for only 1.3% of commissions-based assets, which is virtually unchanged over the past 10 years. Meanwhile, the market share for indexed-based assets, overall, surged to 12.4% of assets in 2017 from 3.4% in 2007, the Morningstar submission states, "thanks mainly to the use of ETFs by fee-based advisors, institutions, and do-it-yourself investors."

Discontinuing embedded commissions would accelerate flows into lower-cost active funds and index funds, the Morningstar submission contends: "We welcome such competition from cheaper passive alternatives, not to displace active managers but to pressure them to become cheaper."

Greater price competition would be "unambiguously good" for investors, the Morningstar submission says. "Lower management fees mean better returns for investors."

In addition, eliminating embedded commissions would lead to a better match between the costs of investing and the level of service investors receive, the Morningstar submission says: "Under the embedded-compensation model, investors receive varying levels of service but pay a single, set price. Costs may be transparent but what investors get in return is not."

Finally, Morningstar rebuffs the industry claim in its submission that scrapping embedded commissions will leave smaller investors without access to advice. Instead, it says that industry innovation, such as robo-advisors, will fill the void between full-service firms and discount brokers.

"We view the rise of digital advice solutions as positive for investors, as these solutions democratize sophisticated asset-allocation models that had been available only to large institutions," the Morningstar submission says.

"By inducing competition and lowering costs, improving transparency and accountability, and driving technological innovation, Morningstar believes investors will be well-served by discontinuing embedded commissions," the firm concludes.

The deadline for submissions to the CSA consultation is on Friday.

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