We noted in 2020 that regulators were continuing with their pre-pandemic agendas. For the asset and fund management sector, one of those priorities is costs and charges. The debate is focused on retail funds but extends across all product lines, including funds for professional investors. It is not only about the disclosure of costs and charges but also about their level relative to performance. The debate is now taking place against a backdrop of increased transaction costs throughout 2020 due to volatility in the markets as a result of the pandemic.
Questions for CEOs
How significant is the impact of market volatility in 2020 on the levels of transaction costs in our funds and separately managed accounts?
Are we explaining the impact as clearly as possible to fund investors and clients?
More generally, are we prioritising meaningful and transparent cost disclosures above commercial concerns about how we appear vis-à-vis our competitors?
Can we justify the level of costs and charges in our funds to an informed and critical audience?
Are we being fully transparent and clear about payments out of fund assets to third parties?
ESMA swings into action
ESMA's second annual statistical report (4.1 MB) on performance and costs of retail investment products, released in April 2020 and based on data from 2009 to 2018, found that while costs in funds remain stable, performance is highly variable and retail investors continue to pay on average 40% more than institutional investors. Actively-managed UCITS outperformed passively-managed funds and exchange-traded funds on a gross basis, but the difference was not enough to compensate for the higher costs charged by active funds.
The report also noted that discrepancies between member states cause data issues. For retail alternative investment funds (mostly open-ended and 16% of the total AIF population), no data were available for costs but gross returns were found to be negative for funds with large retail investor bases (-2.1% for funds of funds and -3.3% for “other”).
ESMA therefore identified costs and performance for retail investment products as a strategic supervisory priority for national regulators (NCAs). The relationship between costs and performance is viewed by ESMA as a key aspect of investor protection. It is concerned about the lack of transparency and undue costs or differences observed in the application of requirements across the EU. It notes that unfair and disproportionate costs and fees can increase investor detriment and affect investors' trust in financial markets. Investment firms and fund managers should have their clients' best interests at heart and ensure that costs and charges are reasonable and disclosed in a transparent and non-complex manner, ESMA said.
At the start of 2021, ESMA swung into action. It is using its enhanced convergence powers to require NCAs to undertake a “common supervisory action” (CSA), to assess the compliance of supervised entities with the relevant cost-related UCITS provisions and the obligation not to charge investors undue costs. Fund managers may be approached by their NCAs for information and should monitor the debate closely.
Inducements under review
The MiFID II review has re-opened the debate about inducements and whether a total ban should be introduced, as exists in the Netherlands
In its advice to the Commission on 1 April 2020, ESMA found that the rules have not had the positive impact intended, or encouraged the development of independent financial advice. However, it noted that a total ban would have different impacts between member states - it could result in banks being more likely to prioritise in-house products and thereby reduce investor choice. ESMA called for a fundamental assessment of the impact of the current inducements regime on distribution, in which the experience of countries that have introduced a total ban on the use of inducements should be carefully considered.
In comments at EFAMA's annual conference in November 2020, the Commission underlined the need to tread carefully. An official noted that there are data to support the assertion that, on average, Dutch and British investors tend to be less risk-averse and have more trust in capital markets. However, concerns over the dominance of bank financing in the EU have made increasing retail investor participation in capital markets a top priority, as evidenced by the new action plan to deliver Capital Markets Union - CMU 2.
The final report by the Commission's High-level Forum on CMU, which has informed CMU 2, warned that a ban on inducements could be counter-productive in countries where investors tend to make investment decisions only with some form of advice or guidance. Forum members were split on whether there should be a total ban on inducements but agreed that a proper study should be undertaken. CMU 2 commits the Commission to assess the applicable rules in the area of inducements and disclosure and, where necessary, propose amendments to existing rules for retail investors to receive fair advice and clear and comparable product information. It will also seek to improve the level of professional qualifications for advisors in the EU.
ESMA Chair, Steven Maijoor has suggested that distribution models whereby the incentives of distributors are better aligned with their clients could also be less onerous in terms of administration and disclosure requirements for the industry. Experience in some countries shows that further restricting the acceptance of inducements can be an effective tool to ensure access to high-quality services and low-cost products.
The jury is likely to be out for some time. Meanwhile, firms may increasingly find they are questioned by NCAs, investors and market commentators on which parties are receiving payments out of fund assets and for what reason.
Meaningful cost disclosure remains illusive
Debate on the PRIIP KID continues. Back in February 2020, the European Commission issued (PDF 1.9 MB) the results of its consumer testing, which suggest that final investment decisions are not affected by the version of the KID offered, but that the document's design can play an important role in aiding investors' understanding of the product's features and in contributing to better informed financial decision-making. The testing had some limitations due to the complexity of the questionnaire, but pointed to:
- inclusion of “probabilistic” performance scenarios is beneficial but only for a small subset of investors
- inclusion of a simple presentation of past performance was helpful, and investors could distinguish between past and possible future performance, but was not tested independently of inclusion of probabilistic scenarios
- no significant evidence to support inclusion of illustrative scenarios for structured products, over and above the use of probabilistic scenarios
The Commission's response to the ESAs' recommendations on changes to the Level 2 PRIIP KID rules underlined a fundamental difference of opinion as to whether changes are needed to the Level 1 text and what can be achieved at Level 2 without such changes. The timeline for any changes remains uncertain, but there have been indications that the Commission may soon announce the way forward.
This article was originally published on kpmg.com by Julie Patterson, Wealth & Asset Management, EMA FS Regulatory Insight Centre, KPMG in the UK.