In April 2018 the Financial Conduct Authority announced a package of measures to boost competition in the asset management sector. These important reforms will mean that managers of authorised funds will need to review and make changes to their governance frameworks, investment objectives and communications with investors. These should be considered alongside preparations for the extension of the Senior Managers Regime to the sector next year. In this briefing, we outline FCA's key proposals and consider how managers can best respond.
Which firms are affected?
The new rules apply to UK Authorised Fund Managers in their management of authorised funds (e.g. open-ended collective investment schemes). Other firms in the sector providing services to authorised funds such as delegated portfolio managers, depositaries and financial advisers, should also take note. The changes are intended to benefit all investors in authorised funds, whether they are retail or professional. The changes do not apply directly to firms managing only unregulated / unauthorised funds (including at least for now, managers of with-profits insurance products or investment trusts), but such firms may nonetheless wish to review the new rules and decide whether to apply any of them on a "best practice" basis.
What is the background to these changes?
The FCA was concerned that there were aspects of asset management where competition was not working effectively (see Terms of Reference). Moreover, it considers that retail investors do not always benefit from economies of scale when pooling their money together. In November 2015, using its powers under the Financial Services and Markets Act 2000, the FCA began a market study using its competition powers and published its findings in a report last June. The FCA expressed concerns across a number of areas as follows:
- price competition - for example, price clustering over charges for retail funds and that some investors are not good at shopping around for best value;
- fund performance - there is no clear relationship between charges and the performance of retail active funds in the UK;
- clarity of investment objectives and charges - concerns about how asset managers communicate their objectives and the phenomena of "closet trackers," where active funds that closely mirror market benchmarks were nevertheless often significantly more expensive than passive funds pursuing a similar objective; and
- intermediaries - there were concerns about the role that others play in the "chain" between fund and investor, in particular: in the investment consultancy market the three largest providers have large, stable market shares, there are low levels of switching and potential conflicts of interest (note that HM Treasury may extend the regulatory perimeter to include such activities). Similarly, there are concerns over the market for investment platforms and whether investors benefit sufficiently.
So what are the measures announced intended to achieve?
These changes are meant to strengthen the regulatory obligations on asset managers to act in the best interests of investors and to better protect their interests. They will also improve transparency over costs, fund objectives and performance reporting. These UK measures come at a time of major change at EU-level, with the recent MiFID II and PRIIPs legislation already containing a number of new obligations targeted at similar issues.
What are the changes?
The changes set out in PS18/8 include the following:
- "value for money" assessment - every year Authorised Fund Managers must look at whether their fund charges are justified by the overall value provided by the fund. The FCA Handbook (COLL) already places a duty on managers to act in the best interests of investors. The purpose of this change is to make managers assess and justify their existing approach. Following feedback, the FCA have clarified their proposal to the effect that fund charges should be assessed on the "overall value delivered" and not just costs;
- independent directors must make up at least 25% of an Authorised Fund Manager's board (there must be a minimum of two). Firms may decide whether or not to have an independent chair. The FCA believes that boards must balance the interests of investors and their shareholders and that this is not achieved where there are no independent directors to scrutinise and challenge decisions. This change, and there is no exception for smaller managers, will likely lead to higher costs;
- new SMCR prescribed responsibility - a senior manager, for example, the chair of the board, must make reasonable steps to see that the firm carries out a value for money assessment, recruits
independent directors, and acts in the best interests of investors. The prescribed responsibility will come into effect at the same time as the extension of the SMCR to the sector in 2019;
- "risk-free box profits" - rules will prevent Authorised Fund Managers keeping profits that arise from the difference between the bid and offer spread on their funds which should go back into the fund for investors' benefit. As part of depositaries' existing duties to test the effectiveness of a fund manager's controls on valuation and pricing, they will be expected to review periodically a fund manager's processes over this requirement; and
- share classes - revised FCA guidance aims to make it easier for fund managers to move investors from older to newer, cheaper, share classes where this is in their interests. Crucially, firms will no longer need to get consent from each investor before converting them. It will be sufficient to simply notify investors (without needing a response) on at least 60 days notice. This guidance takes effect immediately.
What other remedies may still be implemented?
The new measures described above are to be implemented by new rules in the FCA Handbook, which are set out in PS18/8. The FCA considers that further measures might also be needed, and is therefore also consulting (CP18/9) on further action. In this case, it is asking for feedback by 5 July 2018 and the rules would likely take effect later this year or next. The proposals would see:
- communication - new guidance to help firms better explain their fund objectives and investment
policies so they are more "investor friendly." The FCA considers that existing rules on disclosures in fund prospectuses are generally fit for purpose. Nonetheless, to address these concerns it
wants Authorised Fund Managers to explain more clearly what they are seeking to achieve, any constraints affecting how the fund's portfolio is put together (e.g. its differentiation from an index) and, any non-financial objectives (e.g. environmental or social) and how progress against these will be evaluated. The FCA will publish guidance giving examples of poor practice, such as the use of legal terminology or generic descriptions;
- new rules to make firms explain why they use benchmarks (a wider concept than under the EU Benchmarks Regulation) and if they don't, how investors should assess performance. Further, the use of a benchmark will need to be consistent across all fund documentation and a benchmark, which is a target, must be shown alongside past performance data; and
- performance fees - i.e., fees that are taken only once a target benchmark has been exceeded. The FCA recognises that these are innovative and does not appear to be seeking to limit them, but wants to ensure that they are fair to investors. It proposes, for the moment, that such fees must be calculated on performance net of other fees in all cases. It will expressly prohibit taking fees on a gross basis as this amounts to a "fee on a fee." This is also in line with IOSCO's Good Practice for Fees and Expenses of CIS.
What isn't happening?
The Retail Distribution Review (RDR) ended the payment of trail commission by the industry to intermediaries, although existing arrangements made before 2012 were allowed to continue. The FCA is concerned that having to pay commission might make asset managers reluctant to move investors into cheaper share classes. Nonetheless, as the FCA says that it lacks evidence on this question, for the moment, it will allow this practice to continue. The FCA has also decided not to extend its governance proposals to unit-linked and with profits insurance products or investment trusts. It will carry out further work and decide whether action is needed in 2019.
When do these changes take effect?
The governance remedies in PS18/8 take effect on 30 September 2019, the rule on box profits on 1 April 2019, and the new prescribed responsibility with the SMCR on a date to be announced in 2019. The final guidance (18/3) on share classes takes effect now.
What should firms be doing now?
- Review membership of your board and, in the absence of a minimum of two independent directors, take steps to identify and appoint suitable candidates. While the chair need not be independent, consider whether this would be desirable. Remember that from 2019 a member of the board must be allocated a prescribed responsibility in respect of value for investors. This exercise should be carried out as part of the firm's preparation for the implementation of the SMCR in 2019;
- Consider how best to assess and demonstrate compliance annually as to "overall value delivered" to investors (e.g. economies of scale, quality of service, costs and performance). This will require
significant analysis and a change in existing procedures.
- Review the method of calculation of any performance fees to ensure that they are calculated on performance net of other fees in all cases. While this proposal is under consultation it is likely to be
implemented in the near future;
- Review the use of funds generated from risk-free box profits to ensure that any profits arising from the difference between the bid and offer spread are returned to the fund for investors' benefit.
Remember that, in line with FCA expectations, depositaries are likely to want to review (from time to time) an AFM's processes in this regard;
- Review the FCA's guidance on "share classes" and whether it is in the interests of any investors to move to newer, cheaper, share classes. The overall value assessment will be of assistance in this
regard. When investors are to be transferred, notify them explaining why, allowing at least 60 days to pass before proceeding;
- Review the fund's objectives and investment policies to ensure that they are more "investor friendly," drawing on the FCA's examples of good and poor practice. Ensure that any constraints and non-financial objectives are properly explained - with respect to the non-financial objectives this is also required under the PRIIPs Regulation. The materials produced by the Fund Objectives Working Group will be helpful in this respect. Assess also whether references to any benchmark are consistent across all fund documentation, and if it is a target for the fund, that it is shown alongside past performance data; and
- Develop a communications strategy with regard to these changes for investors.
The FCA announced in September 2017 its decision to make a market investigation reference on investment consultancy and fiduciary management services. This work remains ongoing. Additionally, there is a market study into investment platforms where an interim report is due by summer 2018.
The Investment Association is to work with consumers to promote the use of consistent terminology to improve the understanding and comparison of different products. Separately, the FCA has published new interactive forms on its website to help firms preparing to seek authorisation.