The days are over when fund managers could assume that for the majority of investment funds they need do no more than get them authorized, promote them to distributors and let the market take care of itself. Long-term low interest rates are driving a focus on costs. This, coupled with concerns about products not being aligned with customers’ interests, is driving regulatory priorities. New European legislation is breaking down regulatory silos between manufacturers and distributors, and is requiring all firms to consider the whole manufacture-distribution chain.
The recent spate of investigations into 'closet trackers' by ESMA and at least nine national regulators show that even for very plain vanilla funds, managers must ensure that the investment objectives and strategy of the fund are accurately described. Meaningful disclosure has long been a regulatory imperative, with the development of the PRIIP KID being the latest European attempt.
Firms should take seriously the allegations of closet indexing. They need to demonstrate that they are acting unambiguously in the interests of investors, ensuring what it says on the tin is correct and that they do what it says on the tin.
But that is not sufficient. An increasing number of regulators are now asking whether the level of fund management charges is reasonable, as evidenced by the FCA’s Asset Management Market Study and the Central Bank of Ireland’s analysis of fund production costs. They are questioning whether the charging structure of the fund is fully considered as part of the design process or whether managers simply apply a management charge and pay other costs out of the fund that are in line with long-established market norms. Are managers able and incentivized to control third party costs? Are fund investors getting value for money?
This is not just a European debate. Respondents to IOSCO’s recent market study classified harmful conduct as a prominent risk to investor protection. Examples cited were the mis‑selling of products, excessive fees undermining the quality of retail financial products, and deficient disclosure of financial risks leading to investors making decisions on the basis of inaccurate information.
MiFID II brings in for the first time at European level detailed product governance requirements for investment firms. The requirements will also impact UCITS and AIF managers. Although they are not directly subject to MiFID II, distributors are and will have to seek information from fund managers about their product governance process and the “identified target market” of the fund.
For all funds, managers must put in place proper product governance processes, from inception and throughout the life of the fund. They must ensure that products are manufactured to meet the needs of an identified target market of end-clients, that their distribution strategy is compatible with the target market, that they take reasonable steps to ensure that the products are distributed to the identified target market (which requires a regular flow of data from distributors), and that they periodically review the identification of the target market.
The product governance requirements are wide-ranging and cover all aspects of the product design, change and monitoring process, including effective controls, stress testing, identification of the target market, appropriate product information, appropriately trained staff and so on. The Level 2 rules acknowledge that many products can be considered as suitable for the mass retail market, but doing nothing – or very little – is no longer acceptable. Containment of conflicts of interest in general and of inducements in particular are key themes throughout MiFID II, including within the product governance requirements.
They could have significant strategic and operational implications for firms. Although MiFID II is expected to be delayed to January 2018, the PRIIP KID must be in place by the end of this year and includes information on the target market of the product, including for UCITS held within insurance product wrappers. Firms need to start work now on implementing the KID, including identifying the target market for each fund. And they need to talk with distributors about the information needed to be able to monitor whether the fund is sold outside the target market.