Costs and Charges: Regulators Move Into Top Gear

Costs and charges: regulators move into top gear

Evolving Investment Management Regulation 2017

KPMG International

kpmg.com 1 Evolving Investment Management Regulation: Succeeding in an uncertain landscape

This article forms part of the Evolving Investment Management Regulation report, available at: kpmg.com/eimr

Driven by political, regulator, investor and media attention, costs and charges now sit squarely at the top of the reform agenda in the investment and fund management industry. If there was any doubt about the importance of the issue, recent moves by IOSCO and ESMA have removed it. Within Europe, the implementation of MiFID II will bring about fundamental changes to industry commission practices, and a number of other countries, too, have introduced new rules in this area. A number of regulators continue to scrutinize the level of charges and their disclosure. “Closet tracking” remains under the spotlight and the UK, for example, is applying more intensive scrutiny to the level of charges for “active” fund management. Disclosure of the remuneration of senior management and portfolio managers continues to attract regulatory attention.

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transaction. There is less agreement IOSCO guidance on whether implicit costs can be likely to be seen measured retrospectively. Estimating transaction costs in advance is even as cast in stone more prone to variation. There is a risk that predictions of costs could IOSCO’s Investment Management turn out to be so inaccurate as to Committee in August 2016 provided be misleading, and even illegal in good-practice guidance for fees and some jurisdictions. expenses of collective investment These statements are in sharp schemes (CIS). The guidance is not contrast to the EU’s rules for the intended to form comprehensive PRIIP KID on the calculation of future requirements or to impose obligations transaction costs for funds. on national regulators, but both regulators and firms increasingly regard IOSCO’s output as setting the “pass” mark for good operational Efficiency and behavior. transparency – The guidance covers regulated open- ended funds, and closed-ended ESMA sets funds whose shares are traded on the tone a regulated market, and both fees paid directly by investors to the CIS ESMA has signaled it is ready to act. operator or its agent or associate, It believes more can be done and fees or expenses paid out of fund to improve the efficiency and assets. transparency of the investment fund IOSCO describes the latter as falling sector and is working to improve the into four broad categories: information available to investors. 1. Remuneration of the manager, ESMA Chair, Steven Maijoor, speaking including the method of in November 2016 at EFAMA’s calculation of performance fees Investment Management Forum, highlighted that ESMA is committed 2. Distribution costs to building on regulatory and 3. Other fund operating expenses, technology initiatives to achieve such as custody, fund accounting better outcomes for investors. or administration costs 4. Transaction costs associated with ESMA says improving the information purchases and sales of portfolio available to investors will help them assets, including securities choose funds that offer them value for lending and repo and reverse repo money. MiFID II requires information transactions. about third-party payments to be The report makes no observations on provided to clients. This would show regulatory or other expenses that may investors what they indirectly pay for be paid out of fund assets. the services they receive, allow them to understand the total costs and be Many of the good practices focus on able to compare between different disclosure to investors. Information services and financial instruments. should be disclosed to both Additionally, ESMA believes a prospective and current investors stronger focus on cost disclosure and in a way that allows them to make inducements should lead to more informed decisions about whether competition among service providers they wish to invest in a CIS and and, potentially, reduce fees. accept the costs of doing so. This focus on costs and charges The report includes a section on builds on a speech earlier in the year the calculation and disclosure of by Mr. Maijoor. In June 2016, he said transaction costs. IOSCO notes fund managers should bring down the industry consensus that charges on retail funds to align them explicit transaction costs should more closely with fees levied on be determined accurately after the institutional investors.

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... retail investors According to Fitz Partners, a research Payments to are not enjoying firm specializing in fund charges, the divergence of fees charged to distributors – the lower fees retail and institutional investors is charged to seen in both active-managed and a global issue index-tracking products. For instance, professional the average ongoing charge for an In Europe, MiFID II bans commissions clients for similar institutional cross-border equity paid to independent financial advisors products. fund is 0.98 percent, compared with and wealth managers, while payments 1.92 percent for the retail share class. to other parties must pass a “quality Similarly, a retail investor purchasing enhancement” test of the service an index tracker will pay an average received by the client. However, as we 0.43 percent, compared with just noted last year, implementation is likely 0.27 percent for institutional clients. to be patchy at first. Indeed, we see differences in approaches already. Mr. Maijoor said that despite “big demand” for cheaper investment In Sweden and Denmark, for products, European retail investors are instance, the regulators considered not enjoying the lower fees charged to a wider ban on inducements paid professional clients for similar products. to advisors to retail clients, which “We know that the costs of asset would have stopped banks from management products in Europe on accepting payments from third-party average are higher than in the US,” he investment managers. This would go said. “Some of that relates to scale.” further than MiFID II by extending the prohibition against accepting benefits The European Commission has from third parties to cover all advisory signaled it is ready to back ESMA. In services, regardless of whether they February 2017, it launched a study of are independent, as is already the European fund fees and investment case in the UK and the Netherlands. performance. Sven Gentner, head of However, neither Sweden nor Denmark the Commission’s Asset Management proceeded with a fuller ban. Unit, said it is “keen to advance the policy agenda” on fees. The study’s The long lead-time (seven years findings, which will be published by and counting) for the creation and the end of 2017, will “inform policy implementing of MiFID II has given decisions”, he said. European investors regulators elsewhere plenty of time to should be able to compare investment consider the implications for their own products easily but there is evidence jurisdictions. In many cases, they have “this is not the case”. decided on a similar path, albeit with slightly different approaches. In Switzerland, the Swiss Financial Services Act – which will come into force in 2018 at the earliest – includes rules on suitability and appropriateness when providing investment advice or portfolio management, information, documentation, accountability, transparency and due diligence for client orders.

Brexit, Swiss politicians are wondering In a separate move, SEBI is pushing In Japan, draft “Principles for if MiFID II-style regulation is the right managers to merge funds with similar Customer-Oriented Business way to go, given that the EU is less investment strategies in an effort to Conduct” were published by receptive to granting market access to halve the number of funds offered by the Working Group on Financial third countries. It is just possible that domestic managers, and so improve Markets in December 2016. Switzerland may look more to serving costs and operational efficiencies. The principles were conceived other markets than the EU. after it was discovered that fund In Canada, driven by investor managers and distribution agents Simple and protection and market efficiency colluded to hide excess returns concerns, the Canadian Securities from a fund-based insurance meaningful Administrators (CSA) issued a staff product. As a result, many notice in June 2016 proposing cost disclosures ordinary investors – many of them significant changes to mutual fund fees. elderly – were deprived of their The notice focuses on discontinuing remain elusive rightful returns. embedded commissions (sales and In October 2016, the South African The seven principles are: trailing commissions) paid to dealers regulator launched a “meaningful and their representatives. There is also 1. Formulate and publish cost comparison across investment a ‘best interest’ standard for advisors, policy on customer-oriented products”, allowing consumers and dealers and representatives. investment management and advisors to compare charges and their intermediation In the US, the SEC and Treasury impact on investment returns across Department have identified issues most savings and investment products. 2. Pursue the best interest of with the sales practices of certain All members of the Association for customers wealth management firms, specifically Savings and Investment South Africa 3. Appropriately manage their incentive compensation are required to adopt a standard on conflicts of interests structures. Because of their bonus Effective Annual Cost. and compensation structure, financial 4. Clarify commission fees In Europe, MiFID II includes advisors were incentivized to steer requirements for distributors to clients to in-house mutual funds and 5. Provide easily-understandable provide to their clients the total cost other proprietary investment products key information of ownership: aggregate figures for rather than external products that 6. Provide services that are the costs of investing, both within may have been more suitable for the suitable for the specific the product and along the distribution investors. customer chain. The Directive also requires The heightened scrutiny of sales portfolio managers to provide their 7. Design an appropriate practices has prompted some private clients with the total costs of the motivation framework for banks and other wealth management service they receive. The detailed rules employees firms to revise their policies and underpinning these requirements procedures relating to potential are proving contentious, not least as As in Germany, where similar conflicts of interest regarding their regards the methodology for calculating regulation was enacted a decade disclosure and compensation policies. the underlying transaction costs within a fund. ago, the impact on Swiss investment In India, with effect from October management is likely to be 2016, fund investors must be made It is not the only bone of contention considerable. In Germany, the number aware of the amount of commissions for the industry. In October 2016, of managers shrank to 10 percent of paid to distributors out of the total the European Parliament rejected the original due to consolidation. ongoing charges of the fund. SEBI the Regulatory Technical Standards The rules may impact foreign has also instructed fund managers to (RTS) essential for the functioning investment managers. Until now, the show an illustration of the effect of the of the PRIIP KID. As a result, the Swiss regime for managers of separate total ongoing charges on returns and Commission announced a delay of one accounts (as opposed to investment is urging managers to adopt industry year to the implementation deadline funds) has been very liberal in terms of guidelines on capping at 1 percent the while it amended the rules on the company registration and distribution amount of initial commission paid to performance scenarios methodology, of services. However, there could be distributors. the use of the fourth (“market stress”) a twist in the tail. With one eye on scenario, the comprehension alert

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and Multiple Option PRIIPs. The date Meanwhile, many question whether And in the Netherlands, the Dutch for implementation is now in line with the document will be used by Investors’ Forum said its own research the revised deadline for MiFID II of investors. The two-page UCITS KIID, found that less than half of retail January 2018. introduced in 2012 with the arrival investors use the document. of UCITS IV, describes a fund’s However, the hope of a full year for objectives and investment policy, risk product manufacturers to develop, test and reward profile, charges and past Closet trackers: and produce thousands of KIDs has performance. However, representations again been dashed. In another twist, to the Commission suggest that the regulators name in January 2017, the ESAs said they did document is not regarded by investors not agree with the proposed revisions. and shame as useful. After further debate, the Commission took over the lead and issued revised Germany’s fund trade body, the BVI1, In last year’s report (EIMR 2016), we RTS, which were accepted by said in January 2017 that one reason forecast that closet index tracking was Parliament and Council, and published the document has failed is because shaping up to be one of the hottest as final in April 2017. the synthetic risk and reward indicator, European regulatory topics of the year which has a one to seven scale for a and could have significant reputational The new RTS do not, though, include fund’s risk, is unreliable. The BVI said “it repercussions for the fund industry. changes to the methodology for remains to be seen” whether the PRIIP And so it proved. computing costs or their presentation. KID will fare any better. The fund management industry has The debate, already live in many consistently expressed concerns that The UK regulator, in its interim jurisdictions, heated up substantially the presentation of costs could mislead report on its study of the investment after ESMA analysis in 2016 found that investors into thinking they are less management sector, also pointed to a between 5 percent and 15 percent of than they are and that the methodology low level of investor engagement with UCITS equity funds could potentially be for transaction costs will often give the KIID. It said only 25 percent of non- closet trackers – funds that charge an rise to negative or overly-inflated, and advised retail investors look at the KIID active fee but do little more than hug therefore misleading, figures. when choosing a fund. a benchmark. ESMA suggested that further investigation be conducted by national regulators.

1 Bundesverband Investment und Asset Management

EU spotlight on “closet trackers” ... room for improvement regarding the information provided to investors.

Various EU national regulators have reviewed or are reviewing “closet trackers”

Perhaps the strongest reaction to Funds in Germany will be forced to ESMA’s report has been seen in adopt new transparency rules after Norway, where the regulator publicly an inquiry found that some active reprimanded a firm. Most other funds “closely” track their index. The regulators have been reluctant to single investigation into closet indexing, out individual firms. initiated by BaFin in April 2016, looked at 290 funds, each with assets of more Sweden joined its Nordic neighbor by than EUR10 million and each with more announcing in January 2017 that it had than half of their holdings in equities. identified more than ten fund managers that offer funds with a low active share BaFin said there was no evidence that (below 60 percent). However, it stopped any active funds in Germany “solely” short of accusing them of being “closet track an index, but it did identify active trackers”. It, too, named the firms. funds that “closely” follow their benchmark. However, these funds Sweden later proposed legislative tended to have “significantly lower amendments to tighten disclosure management fees than is normal for requirements for fund managers, actively-managed funds”. In addition, the following a high-level inquiry into closet funds are no longer marketed, according index funds. The government will put to BaFin. forward proposals before elections in 2018 for fund managers to “declare The regulator sees no reason to how active or passive [their funds] are”. intervene on this basis, but did say there However, the Ministry said it would still was room for improvement regarding be up to the consumer to decide if the the information provided to investors. fund fee was appropriate. It plans to introduce new transparency requirements for investment funds

© 2017 KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. 7 Evolving Investment Management Regulation: Succeeding in an uncertain landscape

that have more than half their assets Key questions in the UK Asset Management Study in equities. From the middle of 2017, German funds are required to explain explicitly to investors whether they are How do asset managers Are asset managers willing actively-managed or track an index. Fund compete to deliver and able to control costs and prospectuses will have to include the value? quality along the value chain? fund’s long-term performance in relation to its benchmark. Meanwhile, in Italy, the financial How do investors Can investors monitor regulator announced in January 2017 choose between costs/quality of services that “remedial action” had been taken asset managers? paid for out of the fund? against some of the 10 largest fund houses it investigated over the issue. The regulator did not name the fund managers, but said it had forced them to How does the If service providers focus current market structure on winning business from alter their fund documentation to ensure affect competition between asset managers, do they deliver the investment policy was consistent asset managers? value for end-investors? with the actual management.

How do charges and Are asset managers Closet-tracking costs differ along able to control costs identification the value chain? along the value chain? methodologies under the Are there barriers to innovation and technological advances? microscope classified as closet trackers. If national The methodology – or lack of it – for regulators do use a methodology Level of fund identifying closet tracking funds has based on active share, EFAMA believes management fees been questioned by the industry and fund-by-fund analysis, including other some regulators. quantitative and qualitative dimensions, under scrutiny should also be employed. EFAMA, for one, argues that relying The regulatory debate on the level of France’s financial regulator has also on active share and tracking error fund management fees is widening. criticized the methodology. The AMF to determine whether a fund is a In December 2016, the wide-ranging said that based on its own analysis closet tracker is misleading. Small- interim report of the UK FCA’s of the funds identified by ESMA as cap funds, funds with small assets Competition Division’s review of the potential closet trackers, there were no under management and products UK asset management industry was French closet trackers. with a diversified benchmark are tough-talking. It included a number of all more likely to have higher active Meanwhile, campaign group Better damning findings and proposed a series share, says EFAMA, making it easier Finance disclosed the names of of “remedies” for these funds to demonstrate active 62 funds with “high potential” of being share higher than 60 percent. This The report said that active funds closet indexers. Of these 62 funds, compares with large-cap funds or, say, rarely outperform and are guilty of Better Finance said “many” do not funds benchmarked to single-country “considerable price clustering”. It was disclose their benchmark’s performance markets, in which a few companies also critical of the industry’s failure alongside their own performance in represent a large part of the index. to promote passive products to retail their KIID. This makes it impossible for A fund’s active share can also fall in investors. Its stance would appear to the retail investor to assess whether stressed markets as fund managers indicate an endorsement, intended or and by how much a fund is hugging its reduce the size of their active bets. not, for passive products. The regulator benchmark. Better Finance has referred seems to suggest that active funds are its findings to ESMA, which said it EFAMA also disagrees with the view appropriate only if there is no passive would raise the issue with national that funds with an active share of less vehicle that can offer similar exposure. than 60 percent should automatically be regulators.

... an all-in fee that Key FCA findings from the Asset Management would indicate all the Market Study charges investors

• Weak price competition, despite • The ad valorem fee model will pay ... a large number of investment incentivizes growth of assets and fund management firms. rather than value for money. But competitive pressures are • Most expensive funds do not building in some parts of the appear to perform better than market. other funds, and many active • Cost control is mixed – good funds offer similar exposure where straightforward to to passive funds but charge manage and inexpensive to significantly more. control (e.g. safe-keeping of fund • Investors do not receive assets), but less good where estimates of transaction costs in more expensive to monitor advance. value for money (e.g. trade execution and foreign exchange • Concerns about how managers transactions). communicate investment objectives and outcomes. • Charges for passive investment funds have fallen over the last • Investors focus on past five years, but charges for performance, which is not a good actively-managed funds have indicator of future returns. not and are clustered around • Fund governance bodies do not specific pricing points. As fund focus on value for money. size increases, the management charge does not fall. • Firms have consistently substantial profit margins of 36 percent on average.

This stance is at odds with other expert managers, saying the FCA’s proposed Of the four options proposed for the opinion. The Hong Kong regulator, for fee structure will require significant all-in fee, three would require the example, has expressed concern that expense reduction. Moody’s said manager to predict future transaction the rise of passively-managed index- competition from passively-managed costs (as will be required by the PRIIP tracking funds could harm corporate products would require investment KID). Currently, fund managers are governance standards in the territory. managers to “adapt their business required to disclose in the UCITS KIID models”. According to the rating firm, an ongoing charges figure based on Some in the industry have expressed managers that move first “will be most costs incurred by each fund over the doubts to the FCA about the reliability resilient” to changes in the regulatory previous year, excluding transaction and accuracy of the data it used. and market environment. costs and any performance fee. One The UK fund body, the Investment option would require the manager to Association, says the report does not One of the FCA’s proposals is for an pay for any overspend in predicted distinguish between different types of all-in fee that would indicate all the transaction costs. Another would active funds and seems to suggest that charges investors will pay, including require the manager to pay back to the active funds should take on more risk transaction costs incurred when a fund fund any underspend. to justify higher fees. manager trades. The interim report found that “some charges, particularly According to the FCA, an all-in fee would Ratings agencies have also expressed transaction costs, are not disclosed allow investors to “easily see what is doubts over the FCA’s findings. In to investors before they make their being taken from the fund”. A number November 2016, Moody’s noted that investment decisions”. of fund houses have already introduced the regulator’s proposals could squeeze measures similar to the FCA’s all-in fee the profit margins of active fund

© 2017 KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. 9 Evolving Investment Management Regulation: Succeeding in an uncertain landscape

proposals. However, some may set the provide a comparison of fees at a all-in fee figure at a level that is high share class level. The review included The FCA’s proposed enough to “generate certainty” for both actively- and passively-managed remedies to asset investors, which could result in higher investment funds across the spectrum fees. The FCA acknowledges this risk. of equity, bond, money-market and management Most of the criticism in the study is mixed mandates. levelled at the difference between issues Work on fees is due to carry on charges for institutional and retail throughout 2017. The CBI has also Strengthened duty on investment investors and at actively-managed funds. announced it will consult further on managers to act in the best It is said to be difficult for investors to the disclosure of fees and charges. interests of investors. assess the value for money of MMFs, Information gained from this work will protected funds and targeted absolute In relation to investment funds: inform its own contribution and input return funds. External fund ratings are into wider European initiatives on fees. • independence of fund said to be biased towards actively- oversight committees managed funds. In addition, while performance fees are not common in • an “all-in fee approach” Remuneration UK retail funds, where used, they are to quoting fund costs and often asymmetric. charges – rules could go In the institutional market, pension fund • clarity about fund objectives either way trustees said they sometimes struggle • appropriate use of to scrutinize the performance of their In EIMR 2016, we noted that benchmarks investment portfolio as a whole. The remuneration was high on the FCA notes that information presented • investor tools for identifying regulatory agenda, with IOSCO by the investment manager is often in persistent underperformance recommending that the remuneration of a format that is difficult for the client to the management company be disclosed • easier switching into cheaper understand and engage with. separately from other costs and charges share classes The report acknowledges new within investment funds. In Europe, the • clearer communications on requirements under the PRIIP KID debate was focused on the disclosure fund charges Regulation and MiFID II. Some of the of remuneration levels of key individuals FCA’s proposed “remedies” are in line within firms – including senior • increased transparency and with the thrust of these regulations, but management and portfolio managers – standardization of costs and others indicate that the FCA is prepared and the firms’ remuneration policies. charges information. to consider more detailed or, perhaps, As the debate progressed in the latter In relation to pension funds and different solutions. Coupled with the half of 2016, the industry received mixed other institutional investors: already stringent UK requirements on messages on the remuneration issue. inducements, this approach could lead • potential benefits of greater CRD IV, which came into force at the to a greater differential in the regulation pooling of pension scheme start of 2017, includes a cap on bonuses of UK investment markets versus the assets for material risk takers at 100 percent of rest of Europe. fixed salary, or 200 percent where there • increased transparency and Meanwhile, in Ireland, the CBI is is shareholder approval. However, in July standardization of costs and conducting a thematic review of 2016, the European Commission said it charges ongoing charges in UCITS. Its focus was considering waiving strict banking • clearer disclosure of fiduciary is on the quality, comparability and remuneration rules for some non- management fees and presentation of fee disclosures and, in banking groups – including investment performance particular, whether disclosures allow managers. The Commission wrote to investors to make informed investment the European Council and European • provision of institutional decisions. The aim is (a) to build a data- Parliament, saying it would conduct an investment “advice” should driven approach to the understanding impact assessment on allowing rule come under FCA regulation. of ongoing charges and (b) to identify waivers. funds that are outliers. The Commission said the application of The annual submission of UCITS certain CRD IV remuneration provisions KIIDs forms the basis of this review. – particularly those on deferral and In conjunction with other regulatory payout in instruments – “is not efficient returns, the KIIDs were analyzed to if consideration is given to the particular

costs and burdens triggered by the rules in a larger number of investment on the one hand and the absence of management staff in the country falling clear beneficial effects on the other”. within the scope of the remuneration rules. The Dutch Minister of Finance said However, the European Banking he wanted to extend a bonus cap for Authority (EBA) launched a data material risk-takers to all staff at firms collection exercise asking investment caught by the rules, regardless of managers to provide specific information their role. on staff falling under the new rules. In December 2016, it announced The Dutch proposal, which goes further that the bonus cap should apply to than the EU provisions, would extend all firms caught under the Directive, the bonus cap to staff whose functions including bank-owned subsidiaries and are not deemed to have an impact on independent firms. their firm’s risk profile. The Netherlands already has a bonus cap of 20 percent The industry is hoping there will in place for financial services firms. be some flexibility. EFAMA said However, UCITS and AIF managers that imposing CRD IV pay rules on have, until now, been exempt from investment managers will impact firms’ the rules. ability to attract and retain top talent.

In the UK, the Prudential Regulation Investment fund managers must also Authority and the FCA said they would navigate differences between UCITS and not apply the pay guidelines to UK AIFMD requirements. The latter allow standalone fund houses. for the application of proportionality, but the final ESMA remuneration guidelines Similarly, in Ireland, the CBI set out in (which cover both UCITS and AIFs) are January 2017 “proportionality” principles less flexible. The French regulator, for for the payment of variable remuneration one, has clarified that it will align its to certain banks and investment firms. approach to that under AIFMD. Its assessment of quantitative aspects will be guided by threshold levels related to the size of the firm and the level of variable remuneration. The Netherlands, however, is decidedly on the other side of the debate. It has tabled proposals that could result

Jeremy Anderson Tom Brown Chairman Global Head of Asset Management Global Financial Services KPMG International KPMG International T: +44 20 7694 2011 T: +44 20 7311 5800 E: [email protected] E: [email protected]

Fiona Fry Simon Topping Deborah Bailey Head of Financial Services Head of Financial Services Head of Financial Services Regulatory Center of Excellence Regulatory Center of Excellence Regulatory Center of Excellence EMA region ASPAC region Americas region KPMG in the UK T: +85 2 2826 7283 KPMG in the US T: +44 20 76942364 E: [email protected] T: +1 202 533 3443 E: [email protected] E: [email protected] Bonn Liu Julie Patterson Head of Asset James Suglia Head of Asset Management Management National Sector Leader Alternative Regulatory Change Financial Services ASPAC region Investments Regulatory Center of Excellence T: +85 2 2826 7241 KPMG in the US EMA region E: [email protected] T: +1 617 988 5607 T: +44 20 73112201 E: [email protected] E: [email protected] Larry Godin Principal Advisory, Regulatory Risk KPMG in the US T: +1 212 954 1939 E: [email protected]

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