On 28 June 2017, the FCA published its long awaited final report on its asset management market study. The final report, which is over 100 pages long plus five annexes, confirms some of the findings set out in the FCA’s interim report published on 18 November 2016, in particular the FCA’s assessment regarding competition in the asset management industry, communications with investors and practices in the investment consultancy sector generally.
In summary the FCA found that:
- evidence suggests that there is weak price competition in a number of areas of the asset management industry. This has a material impact on investment returns for investors through the charges they pay for asset management services;
- despite a large number of firms operating in the market, the FCA’s sample of firms showed the asset management industry has seen sustained, high profits over a number of years;
- investors are not always clear what the objectives of funds are, and fund performance is sometimes reported against an inappropriate benchmark; and
- there are a wider range of investors in the institutional market. This includes many small pension schemes which rely heavily on the advice of consultants. The FCA found concerns about the way the investment consultant market operates.
The FCA proposes numerous remedies but one of the key points to note is that their implementation will take place in a number of stages so the feel of the final report is not quite the seismic shock the asset management industry originally feared. Overall the remedies can be split into three groups:
- Final remedies that do not require further consultation:
- recommendation that HM Treasury considers bringing investment consultants into the regulatory perimeter;
- recommendation to the Department for Work and Pensions to remove barriers to pension scheme consolidation and pooling;
- recommendation to both industry and representatives to agree a standardised disclosure of costs and charges to institutional investors, asking an independent chair to convene relevant stakeholders to develop this further and working with stakeholders to consider whether any other actions are necessary; and
- launching a market study into investment platforms shortly.
2. Remedies that the FCA is consulting on alongside the final report. The final report sets out the regulator’s overall proposals but the accompanying consultation paper (CP17/18: Consultation on implementing asset management market study remedies and changes to Handbook (CP17/18)) and the letter to the undertakings in lieu parties provides the much needed detail on key proposals that are designed to:
- strengthen the duty on fund managers to act in the best interests of investors;
- require fund managers to return any risk-free box profits to the fund;
- facilitate switching investors to cheaper share classes; and
- proposals to reject the undertakings in lieu of a market investigation reference.
3. Remedies for which the FCA gives its initial views on in the final report and plans to publish detailed consultations at a later stage:
- costs and charges disclosure to retail investors to be consulted on later this year;
- benchmarks and performance reporting to be consulted on later this year; and
- convening a working group on objectives and consulting on any rule changes at a later stage, subject to the outcome of the working group.
In addition, the FCA states that it will publish its decision later this year on whether to refer the market for investment consultancy services to the Competition and Markets Authority.
The FCA consultation
As mentioned earlier CP17/18 is worth scrutinising as it contains many of the FCA’s key proposals. Like the FCA’s final report it is quite a chunky document being some 78 pages long. The deadline for comments on the FCA’s proposals is 28 September 2017.
The FCA states that the proposals in CP17/18 complement other domestic and European work in the asset management sector including the recast Markets in Financial Instruments Directive and the Packaged Retail and Insurance based Investment Products Regulation. Importantly, where the FCA feels that these initiatives will address concerns the regulator is not taking any further action.
Single all-in fee
As initially proposed in its interim report the FCA has said that it is going ahead with plans to introduce a single all-in fee to increase the visibility of all charges taken from the fund and impose more discipline on overspend relative to charging estimates. In the final report the FCA notes that most asset managers preferred the current ongoing charges figures becoming an actual charge, with the manager providing an estimate of any implicit and explicit transaction costs. However, mindful that MiFID II comes into place on 3 January 2018, the regulator has said that further work needs to be carried out and it will consult on proposals later this year.
Grouping of remedies in the consultation
The remedies in CP17/18 can be grouped into the following issues:
- moving investors into better value share classes; and
- risk-free box profits.
The changes that the FCA is proposing are intended to strengthen the rules requiring authorised fund managers (AFMs) to act in the best interests of their investors. Changes are also proposed to the governance structure of AFMs.
In relation to the key issue of scope, the remedies that the FCA proposes will apply to all UK-authorised firms that carry out the function of an AFM for collective investment schemes that are authorised and domiciled in the UK, as well as UK UCITS management companies managing EEA UCITS schemes. But they will not apply to UCITS management companies domiciled in the EEA that are accessing the UK market through the UCITS management passport, nor to full-scope Alternative Investment Fund Managers that operate UK funds, or market funds domiciled in the EEA in the UK. The FCA is also not calling into question the role of the depositary of an authorised fund.
The FCA proposes a new value for money rule which requires an AFM to assess whether value for money has been provided to fund investors. This assessment must take place on an ongoing basis and must be formally documented at least once a year. The FCA proposes that the assessment must consider at least the following points: economies of scale, fees and charges, shares classes, quality of services and transparency.
In terms of increasing the accountability of the AFM board, the FCA states that when the senior managers’ regime and certification regime is extended to almost all financial services firms it will propose a new prescribed responsibility to ensure that asset management firms comply with the obligation to act in the best interests of investors. This new prescribed responsibility will be allocated to the chair of the AFM board and will include assessing value for money in accordance with the regulator’s rules. The chair of the AFM board will also be responsible for taking ‘reasonable steps’ to ensure that the AFM and its board adheres to the rules. As a senior manager the chair of the AFM board will need to be pre-approved by the FCA.
The FCA also proposes a rule that will require AFMs to appoint a minimum of two, and at least 25% of the total board membership, independent directors to the AFM board who meet certain specified requirements. Such requirements include a proposal that independent directors are not eligible for reappointment to the same AFM board until five years since the end of their last appointment have lapsed. Other eligibility criteria include that the individual may not:
- have been an employee of the AFM or of a company within the AFM’s group or remunerated by them for any role other than as an independent board member. This includes participating in any share option or performance-related pay scheme of the AFM or the AFM’s group;
- have been an employee of the AFM or of another company within the fund group within the five years before their appointment;
- have received any sort of remuneration from the AFM group within the five years before their appointment. Also, they may not have had any sort of material business relationship with the AFM or with another company within the AFM’s group within the last three years; and
- they may not have been an employee of any portfolio manager the AFM has delegated to within the five years before their appointment, or have had any material business relationship with that portfolio manager within the last three years.
However, the FCA is not proposing to introduce a rule which limits the number of AFM boards on which a non-executive director may serve. It has also left it to the AFMs themselves to decide whether an independent director should be appointed as chair.
Moving investors into better value share classes
The FCA’s proposals are divided into two issues, investors in pre-RDR classes that no longer pay trail commission and investors in pre-RDR classes that continue to pay trail commission.
In relation to those investors who do not pay trail commission, the FCA proposes to clarify and re-issue the previous guidance contained in Finalised Guidance 14/4 on dealing with hard-to-reach unitholders. It also proposes to clarify that the AFM can undertake a mandatory conversion, if the following conditions are met:
- the power to undertake a mandatory conversion must be set out in the prospectus in line with Collective Investment Schemes sourcebook (COLL) 4.2.5R(5(d);
- the AFM must have made all reasonable attempts to inform unitholders to enable them to give alternative instructions; and
- the AFM is satisfied on reasonable grounds that the change will not result in detriment to investors.
The power to undertake a mandatory conversion must also be exercised in accordance with the client’s best interests rule (COBS 2.1.1R(1)).
The FCA’s current position is that trail commission arrangements entered before 2012 can continue under certain conditions. The FCA is not taking steps to introduce an end date for trail commission legacy business although it states in CP17/18 that “it may consider it in the future”. In the meantime the FCA has said that it is exploring the issue in more detail and welcomes any information that firms may provide that will help it understand the magnitude of the issue and the number of investors affected.
Risk-free box profits
The FCA is aware that some AFMs operate a managers’ box which is a mechanism whereby the AFM, using its own capital, stands between the fund and those investors who are entering or leaving the fund, rather than the investors transacting directly with the fund. In dual-priced funds there is a difference between the price investors pay to buy units in the fund and the price to sell units. The FCA’s concern is whether AFMs might be profiting unfairly from box management.
In CP17/18 the FCA acknowledges that there is currently no explicit rule in COLL that allows profits to be made from box management, although the language used in COLL 6.2.9G implies that the manager could keep risk-free box profits.
The FCA proposes that AFMs will be permitted to retain any profits made from holding positions between pricing points when using their own capital. However, an AFM will be required to pass ‘risk-free’ box profits (i.e. profits generated by netting off transactions) to the fund. AFMs will also disclose their policy on operating a manager’s box and how any profits will be treated in the prospectus. COLL 6.6.4R requires a depositary to take reasonable care to ensure that the AFM manages the scheme in accordance with COLL 6.2. The FCA considers that the impact of COLL 6.6.4R is that depositaries will oversee compliance with its proposed rule changes.
Extending the proposals to other retail investment products
The FCA also sets out for discussion its views on extending the consultation proposals to other types of investment products including unit-linked funds, with-profits business, pensions and closed-ended investment companies. In relation to the latter the FCA states that investment trusts will not be in scope of its proposed COLL rules on AFMs to consider value for money. However, some narrow elements of the FCA’s proposed governance remedies already exist, for example listed investment companies are subject to an ‘independence rule’ (Listing Rule 15.2.11R to 15.2.19R). Also, the regulator notes that MiFID II will introduce, from 3 January 2018, product governance requirements for MiFID II scope products which may include investment trusts. The FCA states that it will consider the impact of MiFID II with regard to fund governance issues for investment companies.
Industry association reaction
The Alternative Investment Management Association has published a response to the FCA’s asset management market study:
“While our industry has not been the primary focus of this study, we do of course support the goals of increased transparency and better alignment of interests between fund managers and investors that are at its core. As our own research has found, alternative asset managers actively discuss with institutional investors about how to deliver the best possible value for money. Dynamic fee structures which include high watermarks, hurdle rates, rebates and differentiated fees according to the size of investments or the length of lock-up periods show that the industry is receptive to investor requests for ever-closer alignment. We look forward to working with the FCA on the next steps in this process.” – Jack Inglis, CEO, AIMA.
The Investment Association has also responded:
“Our industry looks after pensions and investments for millions of UK households, helping them to lead more prosperous lives into retirement. With this role comes significant responsibility. We strongly support the FCA’s objective of ensuring our industry serves its customers in a competitive, accountable and transparent manner.
‘Many of the key recommendations work with the grain of European legislation already in the pipeline to introduce more clarity and transparency for consumers. We will work closely with the FCA as it looks further into the detail of how to present costs and charges in the clearest way for savers and how it will develop more independent oversight of investment funds in a way that is effective and proportionate.
‘We welcome the regulator’s recognition of the industry’s work to date on developing a consistent and transparent disclosure code for charges and costs which can be built on further with consumer groups. The FCA has listened to our calls to make it easier for savers to switch between share classes, which we welcome.
‘Asset managers compete every day to attract clients and investors and are focused on delivering the best outcomes for them. Our priority now is to have a meaningful dialogue with the regulator about the implementation of the recommendations, to ensure savers are getting the best possible deal. A pragmatic timetable is key to achieving this, given the major regulatory changes already in the pipeline and the preparations for Brexit.”
Arguably the FCA’s final report is not as onerous nor as sweeping as the asset management industry had feared. However, with the publication of the consultation paper, a future market study into investment platforms and the possibility of a CMA investigation into investment consultancy services there is plenty more to come. As the title of this note states, the FCA final report was not quite an earthquake but beware of the aftershocks.