Written By: Steve Webster
Much has been made of the impending enforcement of the European regulation MiFID II and its impact on transparency for investors. MiFID II is the sequel to the rather diluted MiFID regulations which were introduced in 2007. One of the key aims of the regulation is to ensure greater transparency by improving the way in which the market trades and reports. Indeed, regardless of Brexit and possible future regulatory equivalence, MiFID II will compel the market to lift the lid on what investors actually pay when they buy and sell investments. No doubt this will be a painful process for those charged with implementing the changes, but for asset owners it should be cause for celebration – and yet I get the feeling that the corks are still firmly in the bottles. Maybe it’s because many just don’t fully comprehend how the proposals will impact them, or perhaps it’s because many just see it as a transactional irritant which may be irrelevant in the big scheme of things. Either way, this new era of transparency cannot be ignored.
Currently, when investors engage in the purchases and sales of investments, many of the costs and expenses are bundled into a price which investors assume is simply… well, the price. Nothing to see here then. However, the regulations will allow investors, as an example, to see how much of their hard earned money / assets are being spent on commissions paid to brokers – a level of insight that hitherto has been patchy at best. The reason that this information is so important is that at present, asset managers trading equities pay a commission to a broker to execute the orders, often receiving expensive research in return. Instead of the asset managers paying for this research out of the management fees that they charge their clients, they simply increase the commission paid to the broker for execution (by the amount required to cover the cost of the research that they receive). And there you have it: by a sleight of hand, the client (who is paying the commission on the value of their investments) has now effectively paid twice for this research. To put this practice further into context, it’s a little bit like a builder who’s paid to construct the extension on your house and then, without your knowing, sells your furniture at the local market, to pay for the roof tiles.
Under MiFID II this behaviour will be prohibited, without the asset owners’ explicit permission. Between now and January 2018, asset managers who “bundle” their cost of research into commission payments (or make the client pay twice), will have to tell clients how they intend to fund this research and if this is via commission payments they must renew each client’s permission every year. But investors should not assume that the implementation of MIFID II alone will provide 100% transparency. The purpose of these new regulations is to force managers to reveal how they are using client money and how much they are paying. Even so, clients will still pay transaction costs, and asset managers will still be free to direct trading flow to their favoured brokers. Therefore, it is beholden on clients to get gain greater oversight of these costs, whether by themselves or with the help of those with the necessary capabilities, so that they can hold their managers accountable for their true expenditure.
The story of hidden cost doesn’t quite end there. As the EU has been finalising the implementation of MiFID II, the FCA has been proposing even greater levels of transparency. In October 2016 the FCA launched a market consultation proposing enhanced cost transparency for Workplace pensions, the initial conclusions of which will be announced in Q2 2017. What seems to differ from previous transparency proposals, is that this paper also seeks to address the elephant in the room, namely implicit costs. Implicit costs are typically the unseen impact of trading caused when an investment manager buys and sells investments in a portfolio. The reason it’s important for a client to understand these costs is simply because while they can have a significant negative impact on performance, they are typically not revealed to clients. Historically there has been an acceptance that these costs were the price of a manager executing their strategy, and as long as they deliver the required net performance, most have tended to believe that the ends justify the means. Apart from the obvious need for clients to be aware of how a manager’s actions are influencing returns, there is further vital information that can be gained from having these insights. A manager that consistently causes greater impact (or more slippage) on performance in pursuit of returns will, all things being equal, likely perform worse as the size of the fund increases. This is simply because the implicit costs of trading (equity assets as an example) increase exponentially with size. In short, the larger a fund becomes the more implicit costs of trading will be a drag on performance. This is what defines true capacity (as opposed to the marketing variant which is used to artificially generate demand!).
Whilst the FCA’s proposals specify that investment managers should be responsible for making the necessary calculations and delivering this new transparency information to workplace pension plans, I do have concerns that some of the intended benefits may get lost in the process. The prospect of multiple transaction cost reports, inconsistent in format and perhaps even some content, landing on the desks of those administering pension plans has the potential to generate more confusion rather than clarity. If this exercise is to be genuinely successful, I am certain that this newly enhanced transparency must be more broadly applied to the entire pensions/institutional investor industry, independently sourced to avoid any conflicts of interest and needs to be presented in as uniform a manner as is possible.
Another area referenced in the FCA’s transaction cost proposals is Swing Pricing for pooled funds. Whilst these references are not a core part of the proposal, they certainly remain relevant to the debate and the interests of investors.
Whilst most of the teaser marketing material promoting pooled funds often make reference to “no entry or exit fee”, there are nevertheless often significant costs incurred on entry and exit, which are generally not widely promoted. Swing pricing simply refers to the premium or discount a manager may apply to a clients’ purchase or sale relative to the size of the investment and any other purchase or sale activity. This cost is applied with the aim of protecting existing investors from the performance dilution effects they may suffer as a result of transactions by other investors in the fund. For example, whilst a new investor might typically get an end-of-day price on the fund they are purchasing, not all of the subscription amount may have been invested that day. As such, the investor’s new money might actually be diluting the fund’s portfolio and therefore its performance, hence the imposition of the swing pricing mechanism.
This might all seem fair and reasonable given the explanation above. However, first, this implied cost is not small (as an example a Corporate Bond Fund might typically impose a 1% swing on entry and exit). Second, the level of transparency doesn’t appear to be consistent, with many funds not openly advertising this implied cost at a factsheet level, or even reporting on it after the event. Lastly, the way in which a swing price may be applied is not always made clear. Generally, a fund prospectus will reference the broad circumstances under which these costs can be applied, but often won’t necessarily explain how they are calculated. Whilst these costs are broadly to the benefit of incumbent fund beneficiaries, without sufficient transparency those transitioning into a fund cannot assess whether they are paying the correct amount to compensate the impact on the other fund investors.
I appreciate that the above considerations in relation to various hidden/less-than-transparent costs of investment may draw an exasperated gasp from some who could be forgiven for thinking “how much information can one pension professional actually absorb when deciding on an investment.” Equally, I fear that any new regime of enhanced transparency which is not properly managed, is at risk of causing an information overload which obliterates any objective decision making in a “whiteout” of data points. However, like the genie that has left the lamp, whilst cost transparency may be an inconvenient truth, the direction of travel, driven as it is by regulatory pressure, is highly unlikely to be reversed. Perhaps most importantly, it will present significant opportunities to reduce costs for those asset owners who embrace this new order. And how often do such opportunities present themselves these days?!