The 200-page interim report on the Asset Management Market Study by the Competition Division of the UK Financial Conduct Authority (FCA) lays down a significant milestone in the wider European debate on fund costs and charges. It contains a number of significant findings and some potentially far-reaching proposals for ‘remedies’, covering both retail investment funds and investment management services to institutional investors. The industry has until 20 February 2017 to comment on the report, following which the FCA will publish its final findings and remedies.
The report follows a period of focus by ESMA and national regulators on ‘closet trackers’ and might influence the on-going regulatory debates on costs and charges disclosures in the PRIIP KID and under MiFID II. Also, Commissioner Dombrovski had already indicated that under the general aim of promoting competition and giving consumers more protection, information and choice, the European Commission is investigating fund performance relative to charges.
More recently, the Chair of ESMA, Steven Maijoor, said at EFAMA’s annual conference that ESMA wants to improve outcomes for investors in EU-based investment funds. It believes that more can be done to improve the efficiency and transparency of the investment fund sector.
Some aspects of the FCA report are specific to the UK market, but investment and fund managers around Europe will wish to reflect on the FCA’s interim findings and recommendations, and the influence they may have on the European-wide debates.
Key findings in relation to investment funds:
The report includes a detailed analysis of fund performance relative to benchmarks and relative to fund charges. It is scattered with references that retail funds on average return less than their benchmark. Apart from one acknowledgement buried on page 108 that the market index is a theoretical construct that does not take into account the costs of investing, the main thrust of the report’s analysis and statements appears to be founded on the presumption that achieving less than benchmark returns is a negative outcome. There is no acknowledgement that a return above cash is the benefit of investing, or that if individuals invest direct they will pay much higher transaction costs and not secure the same degree of diversification of market risk.
Most of the report’s criticism is levelled at the difference between charges for institutional and retail investors and at actively-managed funds. It is suggested that active funds should be used by retail investors only where there is no passive option. It is said to be difficult for investors to assess the value for money of money market funds, protected funds and targeted absolute return funds. External fund ratings are said to be biased towards actively-managed funds. Performance fees are not common in UK retail funds, but where they are used they are often asymmetric.
In the institutional market, pension fund trustees said that they sometimes struggle to scrutinise the performance of their investment portfolio as a whole. Information presented by the investment manager is often in a format that is difficult for the client to understand and engage with. Quarterly reports can include lots of information, which can make it difficult for the client to identify the important points to focus on, so making it difficult to assess performance.
The influence exerted by investment consultants is found to be significant and the market is relatively concentrated, with three firms having about 60% market share. Investment consultants advise clients on asset allocation and investment manager selection, which is not a regulated activity. Some consultants also offer ‘fiduciary management services’, where the consultant itself selects, appoints and monitors the investment manager, with varying degrees of delegation and discretion. The report highlights various potential conflicts of interest and questions whether the consultants’ interests are in line with those of their clients.
Interim proposals on remedies
In relation to investment funds:
In relation to pension funds and other institutional investors:
Further FCA work proposed on the retail distribution of funds, particularly on the impact that financial advisers and platforms have on value for money.
The report acknowledges the new requirements in train under the PRIIP KID and MiFID II. Some of the proposed ‘remedies’ are in line with the thrust of these regulations, but some indicate that the FCA is prepared to consider more detailed or, perhaps, different requirements where it deems necessary. Coupled with the already more stringent UK requirements on inducements, this approach could lead to a greater differential in the regulation of the retail and institutional investment markets between the UK and much of the rest of Europe. One particular area of focus is the proposal for an ‘all-in fee approach’ to quoting fund costs and charges.
Of the four options proposed, three would require the manager to predict future transaction costs (as will be required by the PRIIP KID), but one would require the manager to pay for any overspend in predicted transaction costs and another would require the manager to pay back to the fund any underspend. Also, whichever option is decided upon, it might be introduced ahead of the UCITS exemption period in the PRIIP KID, which could not be imposed on non-UK UCITS marketed to UK investors.
Critical questions for firms to address: