Fidelity’s announcement last week that it will be adding a performance element to research costs under the upcoming Markets in Financial Instruments Directive II (MiFID II) has rocked the fund management industry. The company said it will move investors to a new “variable” share class with significantly lower costs but with a new performance fee – which is refundable if the funds fail to beat the benchmark.
In the last few weeks alone, a raft of asset managers finally confirmed that they will - no doubt after much debate and discussion - absorb the costs of equity research themselves, rather than pass them on to investors in their funds. The likes of Schroders, Janus Henderson and Invesco have all publicly reversed their decisions in recent days, having previously made public their intention to pass on research charges to investors; they are now prepared to take the hit themselves.
Our view at Morningstar is that the issue of passing on research costs to investors shouldn’t even be a discussion. Morningstar global ratings leader, Christopher Traulsen, made this very clear when he published an article in May with the premise that fund managers need research to do their job well, for which the investors are already paying them a management fee. Why would an investor, who is already paying a premium price for active management, pay anything additional for research?
Why Should Investors Pay More?
MiFID II is much wider-reaching than the unbundling of equity research and trading fees, though. There is a raft of new data points that asset managers will need to disclose for funds offered to the market. Granted, these two areas have been consuming much time and effort by asset managers, as the regulators clarify exactly what data points they need to provide. What’s less talked about is that, in addition to disclosing new data points, asset managers will also need to review their own investment products on a regular basis, in much the same way as distributors need to periodically review their product lineup.
Chapter Three of the Delegated Directive requires the investment firms of member states to check whether their own funds are still fit-for-purpose and relevant for today’s investors and that they offer good value. They will need to check that their products function as intended and not wait for any detriment to occur. They will now be obliged to review their products when they become aware of an event that could materially affect the potential risk to investors. Not only do investment firms need to carry out these checks, they must prove that they’re doing this as part of a ‘regular review of products.’ There is no timeline or frequency specified in the Directive; we believe a best practice would be to do this at least on a semiannual basis, although we think it’s more likely that it will be done annually.
We think all firms would do well to follow the approach of the Financial Conduct Authority in the United Kingdom. The FCA is adopting a 'gold plating' approach to the directive: It is proposing to adopt a number of enhancements to its own regulations from those that have been set out in MiFID II, with investors’ interests and protection fully at the forefront - the aim being to ensure best practice. Although the FCA already implemented changes following the Retail Distribution Review in 2012, the addition of new fund data points, such as those relating to target market and suitability, should enable advisors to improve the quality of advice even further.
Complacency Among Asset Managers
We like the fact that MiFID II will shift the focus of product distribution from product sales to the investor, and that the FCA is wholly supportive of this. Having watched the number of share classes of funds available for sale in Europe grow at an exponential rate in the last decade, I confess to harbouring some hope that this requirement on the asset managers, which must be proved through an audit trail, will eventually lead to the closure of some long-established funds - relics of the 80s and 90s that still exist because the assets are sticky but where it can be argued that indifference has set in. Even though some of the funds have less relevance in today’s investing world, and notwithstanding the fact there would be costs involved in fund closures, there is complacency among asset managers. Investor inertia - or lack of awareness - also plays a role.
We believe investors would certainly benefit from the asset management industry taking a long, hard look at the funds it offers and asking itself these questions: is every fund in its lineup relevant? Are they priced competitively? Does the firm have the right skill set and expertise to manage these funds well? However, not all asset managers will fall into the scope of MiFID II, and thus they won’t be obliged to undertake this review. For example, those that have been authorised as Alternative Investment Fund Managers (AIFMs) under the Alternative Investment Fund Managers Directive (AIFMD) and are marketing or managing the AIFs for which they are an AIFM are not in scope. Firms that have been authorised as UCITS management companies under the UCITS directives are also out of scope when managing or marketing the UCITS funds for which they act as UCITS manager.
A further challenge for MiFID II is that, as a directive, it requires adoption into local law by each European Union member state, and this can lead to differences among those states as they choose to interpret or implement it in their own way. We think it is important for both manufacturers and distributors alike to review funds through the same lens, using the same inputs, irrespective of how the directive is adopted locally. So, we have developed a range of due-diligence scorecards to facilitate exactly that. Whether you’re the asset manager looking at your products or an advisor looking at the funds you recommend, our due diligence scorecards give a consistent framework through which to do this analysis.
We’ve based our scorecards on the proprietary five-pillar rating methodology that underpins our Morningstar Analyst Rating. The scorecard assesses a lineup of funds using a multitude of data points on a quantitative basis and gives them a peer group ranking. This means the manufacturer can see exactly how its funds are being assessed by the distributors, and any flaws, such as high fees, will stand out. Given the need for those firms that fall under MiFID II to show proof of an audit trail of these assessments, questions will soon be asked if such flaws are evidenced regularly as part of that review, yet repeatedly ignored. Any positive action on the back of such a review, which shows a clear benefit to the investor, will potentially see greater interest by investors and their advisors, as that firm will be demonstrating good stewardship of investor assets.
Take the recent announcement from Barings that it is closing a handful of funds because of their lack of viability - Baring UK Growth Trust, in particular. That fund sits in the UK Large-Cap Blend Equity Morningstar Category, in which five funds carry an Analyst Rating of Silver, and seven a Bronze rating. In other words, there’s no shortage of good funds in that category. The Barings fund has existed since late 1987, yet its asset base is low. It has underperformed its category peer in six of the last seven calendar years, and its ongoing charge for the older A share class is around 1.7%. Those high fees are in part a function of the small asset base. Nonetheless, it is good to see an acknowledgement by the firm that the management of a UK equity fund is not its core skill set. That fund would have been flagged up multiple times in our due-diligence scorecards, with performance issues as well as fees.
MiFID II Will Benefit Investors
For the distributor, best-interest advice can only be given if you start with the best investments. Morningstar’s independence makes us well-placed to assist, as our research is fully independent. We say it how we see it. Advisors can rely on us to help them find the best investing ideas through our Morningstar Analyst Ratings. We’ve been assessing funds for more than 30 years and therefore support MiFID II, as it aligns so well with our views. We’ve always advocated transparency for investors, and we have always put investors’ interests first. We believe that the industry developments brought about by MiFID II will be good for investors. High fund fees will be exposed, and the manufacturer will no longer be able to ignore the continued existence of funds that have lost their way.
We have always viewed price as a key component in a fund’s success or failure. The increase in fee transparency, brought about by MiFID II, is very welcome, in our view. Asset managers will be required to break down costs into four main components for a fund: the ongoing charge; one-off fees such as entry and exit fees; incidental fees, such as any performance fees; and the transaction fees related to the investment product. This will give investors a clearer picture of what they’re paying for, which in turn will help them decide if they’re getting value for money.
The implementation of the Retail Distribution Review in the UK saw the introduction of a ban on inducements, meaning investors can now see the cost of the advice they’re receiving, and know that there is no undue influence on that advice. This is not as clear-cut in Europe under MiFID II.
For example, the German government is taking the stance that its nation’s banks have wide-reaching branch networks providing services and financial advice that their clients might not otherwise have access to; so, Germany will allow the banks’ advisors to continue to receive inducements on the view that the banks' scale effectively improves the quality and reach of advice they are able to offer. We wonder how long Germany will be able to retain this stance and demonstrate that this does indeed hold true.
We welcome the regulatory changes that MiFID II will bring, and we see so many positives that can and will arise from it. It is far more than just a compliance exercise. At the heart of the directive is the objective to make investors more informed in a way that is comparable, and to give them better-quality advice that matches their suitability and needs. That should lead to a better investing experience, and when the investor wins, we all win.
Learn more about how Morningstar can help financial professionals prepare for MiFID II
