The European Securities and Markets Authority (ESMA) is following the lead of the Financial Conduct Authority (FCA) in the UK by looking at fund competitiveness and joining the industry’s active versus passive funds debate.
Leaders and Followers
The FCA tends to be at the forefront of regulatory thinking. It is far from unusual for a policy initiative born in the UK to take root in other jurisdictions. This can range from regulatory sandboxes, to senior management certification regimes, or commission bans for retail fund sales. One of the most significant regulatory publications of 2017 came from the FCA when it issued its long-awaited Asset Management Market Study. One of the top findings from the study relates to the relative merits, costs, and performance of active and passive funds. The European Commission recently mandated that ESMA conduct a Europe-wide market study similar to the FCA’s. ESMA has now announced it will launch an assessment of costs and past performance of UCITS funds to “increase investors’ awareness of the net return of these products, and the impact of fees and charges.”
ESMA will be acutely aware that some industry stakeholders, while in many ways acknowledging its merits, challenged various premises and conclusions of the FCA’s cost assessment. Asset managers, banks, and insurers questioned elements of the methodology, assumptions, and sample size and some disputed the FCA’s findings.
ESMA also has prior experience with industry push back on empirical studies. In 2016, ESMA assessed the UCITS fund market testing the hypothesis that certain active funds, which typically charge higher fees than passively managed funds, in practice tracked benchmarks in a manner more suited to passive funds. The 2016 ESMA paper suggested that up to 15% of UCITS equity funds might be more appropriately categorized as passive funds. Some UCITS fund managers questioned ESMA’s methodology and the resulting scale of potential mischaracterization as a headline figure.
ESMA plans to be more transparent on their sampling, methodology, and in the initial paper provided a significant body of independent academic and market led research to back up their assumptions. Industry stakeholders are more likely to accept findings and subsequent policy shifts if empirical evidence and methods used are considered accurate, independent, and transparent.
Unfortunately, the current initial report contains minor typographical errors that would seem to misstate the impact of fees on net returns being reported incorrectly. Given the importance of accuracy and presentation of empirical evidence in garnering wide stakeholder acceptance, it is hoped and expected these errors will be adjusted correctly.
An age-old irritant for investors is lack of transparency and standardization in how financial product fees are described and disclosed. This inability to easily access how much retail investors are paying has led to a recent raft of regulatory policy decisions aimed at increasing transparency. UCITS V, AIFMD, PRIIPS, and MiFID 2 have all included product fee and costs disclosure requirements. However, each of these regulations utilizes different methodologies to calculate the required disclosure amount. This could leave investors without the ability to effectively compare, contrast, and collectively understand the upfront and ongoing costs of each product. The FCA has suggested an “all in fee” to remove inconsistencies, but that still wouldn’t clarify the overall composition of fees and ongoing costs within financial products. Asset managers have an opportunity to get in front of this concern by better defining fee components and costs.
Prescribing Transparency or Influencing Investors?
The purpose of ESMA’s study is to assess “the reporting of costs and past performance of retail investment products, to increase investors’ awareness of the net return of these products, and the impact of fees and charges.” Since fee and cost transparency requirements are already prescribed under the UCITS regime – as well as pursuant to other legislation – a question might arise whether authorities are seeking to influence investor behavior when they select among different investment options or products.
The role of regulators continues to evolve. Since the financial crisis, regulatory authorities tend to focus on investor protection, financial stability, and containment of systemic risk. However, beginning in 2016 with its Capital Markets Union (CMU) project, the European Union has signaled a policy shift towards economic growth. Key elements of the CMU agenda include improving the environment for cross-border capital flows (including through investment funds) across the EU and across many different sectors.
As a result, various new and ambitious initiatives have emerged, including the Pan European Pension Product (PEPP). PEPP aims to increase pension participation across the EU without regard to national borders, and the adoption of fintech sandboxes where regulators facilitate the testing of technology solutions without the full weight and cost of regulatory authorization initially. Efforts by regulators to encourage industry innovation are expected to continue.
ESMA’s preliminary evidence suggests the following:
- Large reductions in retail investor returns are caused by fees and charges
- Retail investors may not understand the impact of upfront and ongoing fees on the performance of their investments
It cannot be denied there is some truth in these statements: without question it is appropriate to look more closely at fee structures and transparency. At a minimum, with an omnibus review of UCITS and AIFMD already planned in 2018, this study will make it another busy year for ESMA and asset managers operating in the EU.