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FCA Regulations Require U.K. Asset Managers to Demonstrate Fund Value

The regulations, which take effect on Sept. 30, will bring U.K. funds a step closer to U.S. governance

Andy Pettit

 

U.K. funds are set to move a step closer to a governance process like that of U.S. mutual funds. New regulations, which take effect on Sept. 30, 2019, aim to strengthen obligations for asset managers to act in the best interest of investors. 

The Financial Conduct Authority (FCA) imposed these changes as part of a larger package of remedies, which emerged after its Asset Management Market Study found evidence of weak price competition and high profits in the asset-management industry.  

A closer look at the U.K. funds rules 

A few of the rules include: 

  • The requirement for each fund entity to ensure at least a quarter of its governing body is made up of independent directors, or that it includes at least two independent directors if the board is less than eight members. While there is no independence requirement on the board chair, they will have a new responsibility for ensuring a detailed annual assessment of fund value provided to investors.

  • Guidance on how asset managers could describe fund objectives in ways more useful to investors.  

  • Funds are required to start explaining why or how they use indexes as benchmarks and, if they do not, how else investors should assess the fund’s performance. 

We support improving clarity and transparency for investors, but it remains to be seen if it comes at a price. Index licensing fees are notoriously high, and the costs could fall into a fund’s ongoing charge and then pass on to investors. With funds citing up to three benchmarks, under FCA terminology—a target, a constraint, and a comparator—costs could multiply.  

Alternatively, this market-study remedy could be a catalyst for firms to assess the benchmarks they use, their cost and whether alternatives are available.  

How fund value should be assessed 

The new assessments of value are comparable to section 15(c) obligations of the U.S.’s Investment Company Act of 1940, which can provide useful pointers for U.K. funds. 

The FCA modelled the assessment of value rules on the Gartenberg factors that underlie the 15(c) process:  

  • Quality of service 

  • Performance 

  • General costs 

  • Economies of scale 

  • Comparable market rates 

  • Comparable services  

  • Differences between share classes 

Beyond that, the FCA has been deliberately nonprescriptive in defining the assessment process and the content of the summary statement. This enables fund firms to be innovative and create best practices in both the assessment process and how they publicly report the justification of a fund’s charges in relationship to the overall value it provided. 

Fee changes demonstrate some early investor successes 

Independently assessing the value on each share class will turn a spotlight on legacy classes. 

Share classes proliferated since the Retail Distribution Review in 2012, which banned advisers and distributors from receiving commissions from funds on new business. However, the assets in many of these legacy classes still dwarf those in the newer, cheaper commission-free classes (or clean share classes). 

To date, legacy classes’ fees have been explained by the extra costs the fund incurs in servicing those investors directly. Now, funds will have to specifically articulate the value that investors are deriving from this extra cost (typically 50-75 basis points).  

In addition to this putting pressure on active funds, some passive funds can also expect to feel the heat, as a few infamous U.K. index trackers have levied annual charges of more than 1%. One of these trackers, Virgin UK Index Tracking Trust, acted ahead of time in January and reduced its fee to 0.6%, though that’s still toward the expensive end of the range. 

Additionally, the economies of scale factor can identify if savings are achievable as assets under management grow. If so, the assessment of value will require asset managers to identify if those savings have been realised and whether they’ve been passed on to investors. 

M&G recently became one of the first large fund firms to do this through breakpoints, where fees drop when a fund’s assets reach specified milestones. However, in its evaluation of M&G funds, the Morningstar Manager Research team remains Neutral on the Parent Pillar and Negative on the Price Pillar, as the tiered-fee discounts were not enough to render the firm competitive against peers. 

How assessments of fund value reflect performance 

The assessments of value will help determine whether the charges taken from a fund are justified in the context of the overall fund value, which will be predominantly judged by whether the return is in line with the expectations set when investors bought the fund. Those expectations might include absolute total return, outperformance or tracking of a target benchmark, and provision of steady or growing income. 

While funds that use benchmarks as targets or constraints will have to disclose them in the assessment, in contrast to the cost factors, performance doesn’t have to be assessed relative to peers. This is like the 15(c) process, except U.S. fund boards typically conduct this peer-relative assessment as part of their decision-making about renewing an investment adviser’s contract.  

For funds choosing to assess their performance relative to peers, it will be key to ensure consistency in time periods assessed and the selection of peer groups of comparable funds. Any changes from year to year may be open to charges of cherry-picking to show a fund in the best light.

Boards concluding that fund charges are not justified will have to provide a clear explanation of remedial actions that have or will be taken. In this context, one of the most eagerly awaited assessment of value statements will be that of the LF Woodford Equity Income fund, which is due on April 30, 2020. We look forward to exploring the statement considering ongoing criticism that the fund continues to levy charges on investors while it remains suspended. 

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