“Nowadays people know the price of everything and the value of nothing”
– Oscar Wilde, The Picture of Dorian Gray
Three years ago, the UK’s Financial Conduct Authority (FCA) published its findings following a wide-ranging asset management market study. One key finding of the study was that in the FCA’s opinion UK funds did not provide good “value” to investors. The shift in emphasis by the FCA from accurate disclosure to an assessment of value represented a fundamental change in how regulators viewed fees. Previously, investors were left to shop around and assess value for themselves with the regulator’s role to ensure fund fees were visible, understandable and accurately accrued within funds thereafter. The FCA’s value assessments moved away from the long-held concept of “caveat emptor” and shifted the burden of assessing value to the managers and board of directors of the funds.
Recently, we have seen the publication of the first swathe of “Assessment of Value” reports by UK funds. They have captured much market attention and commentary on a host of issues ranging from performance fees, benefits due to economies of scale and requirements to move certain investors to lower priced share classes. However, equally significant to the specifics of the UK value assessments, is that other regulators, like ESMA, appear to be equally interested in knowing whether EU funds are providing investors value for money.
On June 4, ESMA issued a rather innocuous looking guidance paper entitled, “Supervisory briefing: On the supervision of costs in UCITS and AIFs”. The briefing was framed as another in a long line of ESMA regulatory convergence publications looking to ensure harmonization of approaches across all EU27 member states with respect to fees. Following an ESMA survey of EU27 regulators, findings show certain divergence in interpretations and supervisory approaches on fees, which made identification of “undue costs” difficult on a pan-EU basis. Delving into the new requirements makes it evident that ESMA’s paper could have significant consequences for boards and management companies of UCITS and AIFMD funds.
ESMA’s reasoning behind the paper is a desire to increase trust and ultimately foster greater retail participation in EU funds. Recently, Steven Maijoor, Chair of ESMA, has been emphasising trust: “One of the key factors to mobilising investor participation in capital markets is to ensure that their trust in financial markets is improved and costs associated with buying financial products are reduced.”
The levels of granular review required to assess fund fee levels – i.e., whether those fees represent “value” to investors and whether on that basis they stack up well against peer-products in the market – reflect not only a philosophical shift but also a bottom-line increased burden on those who oversee funds. All EU investment fund board members, and asset managers would be well-advised to pay close attention.
This latest release follows hot on the heels of a prior ESMA publication in April, which focused specifically on costs to retail investors in funds and the performance erosion of such fees while also flagging how much more expensive it was to invest for UCITS retail investors than for institutional investors. For ESMA, this was another step closer to a “value for money” mindset.
The release tasks UCITS & AIFMD management companies with assessing whether costs are sufficiently
“linked to a service provided in the investor’s best interest” and are “proportionate compared with market standards.” This adds both qualitative and comparative appraisals to the review of fees that currently do not exists with respect to EU funds. For the first time, ESMA explicitly addresses issues of product competitiveness and not merely their adherence to required levels of disclosure, suitability, and accuracy.
Pricing Process & Undue Costs
In concrete terms, the new requirement is that EU management companies produce a “pricing process” document to identify and quantify all costs charged to the funds. This would apply to all UCITS and AIFMD funds and would be in addition to existing fee disclosure requirements under those regimes as well as in addition to MIFID 2 and PRIIPS requirements. The pricing process must be conducted at the initial launch stage for new funds and maintained on an ongoing basis. Existing funds must also implement the process on an ongoing basis as well.
The proposals also move beyond nominal fee disclosures and effectively impose a detailed analysis report created and maintained for every sub-fund which is self-assessed to ensure (a) there are no “undue costs” applied (b) are generally in line with peer products in the market. ESMA outline a series of questions, ten in total, which form the basis of the proposed pricing process.
In alphabetical order, the ten questions are as follows:
- Appropriate – Do fee levels match the funds level of complexity?
- Capped – If fees are capped, are they properly disclosed and functioning correctly?
- Disclosed correctly – Are all costs clearly disclosed in line with applicable regulatory requirements?
- Double dipping – Are costs properly and separately accounted for in all instances?
- Fair – Do the fees prejudice certain investors e.g.: retail versus institutional share classes?
- Independently verified
- Performance Based – Do performance fees align with ESMA guidelines?
- Reasonable – Are fees aligned with similar products available in the market?
- Sustainable – Are fees aligned with the funds’ size and expected returns?
- Valid – Do fees align with investment objectives and return expectations?
The paper further suggests that where instances of “undue costs” are identified by the regulator using the criteria above, the regulator may demand providing for investor redress through compensation or fee reductions. Therefore, funds not assessing value appropriately could see regulators formally intervene, which is a step even beyond the FCA’s approach.
ESMA’s recommendations are not binding, but are very likely to be accepted in full, particularly in Ireland and Luxembourg, the two primary UCITS & AIFMD domiciles. Therefore, UCITS and AIFMD funds, their boards and management companies should start gearing themselves up for the new pricing process regime. There has already been a degree of regulatory focus on UCITS fees and new fund authorizations in Ireland and Luxembourg where further justification of fee levels has been a component of recent reviews. While the concept of assessing value is already growing, the ESMA guidance crystallizes this shift to value rather than cost.