FCA asset management market study: Final report and consultation
Will the Financial Conduct Authority’s (FCA) findings of weak pricing competition in the asset management market and proposed changes result in a more competitive industry which functions better for investors? Michaela Walker and Julian Brown, Partners in the Financial Services Regulation Team, and Julia Woodward-Carlton, Partner in the Competition Team at Eversheds Sutherland discuss the impact of the FCA’s final report on the asset management market study.
How did the FCA asset management market study come about?
The FCA published its long-awaited final report on the asset management market study (Final Report) together with an initial consultation paper on remedies (CP17/18). Building on its interim report from November last year (Interim Report), discussed by Eversheds here, the FCA has confirmed its earlier findings that there is weak price competition in a number of areas of the asset management industry. The FCA recognises that ongoing European legislation, together with the wider Brexit discussions, will have an impact on many of their original proposals and they have taken this into consideration when proposing their next steps in the final report. The FCA has equally recognised that many of the proposals will lead to an increase in costs for asset managers (which presumably they do not anticipate will be passed onto investors) but its view is that, overall, the proposed changes will result in a more competitive industry which functions better for investors.
The FCA is seeking responses to Consultation Paper CP17/18 by 28 September 2017 with final rules likely to come into force in 2018 with either six or 12 month transitional provisions dependent on the remedy. The remaining CPs are expected by the end of 2017.
What are the key findings from the FCA’s final report?
The FCA found four key concerns:
- weak price competition in a number of areas of the asset management industry; firms do not typically compete on price, particularly for retail active asset management services
- in a comparison between price and performance the FCA found substantial variation, and no clear relationship between charges and the gross performance of retail active funds in the UK
- a lack of clarity of objectives and charges. The FCA highlighted concerns about how asset managers communicate their objectives, as investor awareness was mixed and often poor, and
- a significant differences in both the behaviour and outcomes of different institutional investors. Large institutional investors are able to negotiate very effectively and get good value for money. However, the FCA also identified a long tail of smaller institutional investors, typically pension funds, who find it harder to negotiate with asset managers
What are the key FCA proposals?
In response, the FCA is proposing a number of potentially significant and intrusive remedies which are designed either to protect investors or to drive competitive pressure on asset managers. The remedies are split into three categories:
- those which are subject to CP 17/18 (for which responses are required by 28 September 2017)
- those on which FCA will consult further in the later part of this year, and
- those which are final remedies and will be implemented immediately
What remedies are subject to the current Consultation Paper (CP17/18)
A strengthened duty on asset managers to act in the best interests of investors
The FCA intends to use the Senior Managers and Compliance Regime (SMCR) to do this and ensure that asset management firms comply with the duty to act in the best interests of investors. The FCA will expect this duty to cover an annual ‘value for money assessment’. The FCA has identified a number of themes which firms may need to consider as part of this assessment such as the degree of active management for a fund and how pricing can be structured so that investors can benefit from economies of scale.
A prohibition on retention of risk free box profits
The FCA are consulting on how such profits can be returned to the fund and how box management processes are disclosed to investors. This was a widely expected proposal.
A requirement for fund managers to appoint a minimum of two independent directors to their boards
This does not go as far as might have been proposed, as the FCA have stopped short of moving to a US model of governance in relation to fund boards as was proposed in the Interim Report. However, the appointment of at least two (and no less than 25% by number) independent board members remains a significant change. There are a number of suggested requirements for such board members, including that any such board member may not have received any remuneration from the fund manager’s (AFM’s) group (presumably for any role other than as an independent board member) in the previous five years. The FCA recognises that this level of independence may present practical problems for the industry and as such there is a proposed 12 month implementation period.
Making it easier for investors to switch between share classes
A proposed remedy which will be welcomed by most fund management houses, if not necessarily by intermediaries, is to make it easier to switch unresponsive investors from one share class to another better value class. The proposed conditions for being able to effect such switches, of prospectus disclosure, the AFM having made all reasonable attempts to contact holders and the AFM being satisfied that the change will not result in detriment, are sensible requirements which will lead to a reduction in legacy, expensive share classes. The FCA proposes to clarify and reissue its existing guidance on changing clients to post-RDR classes as part of the CP. The CP also asks for views on whether or not payment of legacy trail commission should be ended – see below.
Consulting on whether to make a market investigation reference to the Competition and Markets Authority (CMA) for in-depth investigation of the institutional investment advice market
The FCA received undertakings in lieu of a market investigation reference (UILs) from the three largest investment consultants which were, in particular, to disclose charges and performance information in a standardised format, and implement changes to address conflicts of interest and strengthen internal processes. If accepted, these UILs would have negated the need for a market investigation reference to the CMA (MIR).
The FCA’s provisional view is to reject the UILs because, among other things, they cover only approximately 56% of the market, potentially leaving competition issues in a significant proportion of the market unaddressed; and, more significantly, the FCA cannot be confident that structural remedies will not be necessary given the conflicts of interest identified as arising out of vertically integrated business models. Such structural remedies are generally seen as a draconian or extreme form of market intervention – a market investigation would enable the CMA to carry out an in-depth inquiry and determine whether structural remedies are necessary. The FCA will continue to consult on rejecting the UILs and making the MIR, with a final decision expected in September 2017.
As well as consulting on the proposed remedies from the market study the Consultation Paper seeks views on two further areas. The first of these is whether or not legacy trail commissions should be ended. The second is whether the remedies proposed in the market study should be applied to other investment products such as closed ended funds, pensions, unit-linked and with-profits.
What remedies will be subject to future consultation (expected by the end of 2017)?
Introducing a standardised disclosure of costs and charges to retail investors
One of the most talked about proposals of the Interim Report was the ‘all-in-fee’ and which of the four proposed options for charging structures the FCA would choose. However, the final report makes it clear that the FCA do not, at this stage, intend to move forward with any one of the options. Instead, they recognise the work being done in these areas under MiFID II and PRIIPs and have chosen to concentrate on disclosure and transparency instead of any radical change to the way in which charges are packaged. They are considering, for example, whether wider use of pounds and pence disclosure should be introduced and the benefits of consistency between point of sale and ongoing disclosures. The FCA’s intention is to monitor the effectiveness of MiFID II and PRIIPs, together with the impact of the governance reforms, in the expectation that together these remedies will be sufficient – for now.
Consulting on benchmarks and performance reporting
For example, the FCA will consult on whether performance fees should be allowed only where the fund performs above the most ambitious target.
Introducing a working group on investment objectives
The FCA are continuing to explore options to improve the language used in, and clarity of, objectives. To this end, the FCA will chair a working group on the issue and consider whether that group’s output should be turned into rules on how fund objectives should be written.
Following the proposals in the Interim Report, the FCA confirm that they do not believe all funds should be required to use a specific benchmark, comparator or other numerical target. However, whether a fund does or does not, the FCA will expect that managers will explain the reasons for their choice. In addition, if a fund chooses not to use such a benchmark, comparator or other target, it will be prevented from using any other comparator or benchmark in marketing materials. If a benchmark is used, the rules will require this to be used consistently across all regulatory and marketing materials.
Since the FCA’s Thematic Review on Meeting Investors’ Expectations there has been a move towards disclosing benchmarks and introducing comparators but further work would be required if the FCA move forward with this proposal.
What are the final remedies?
- Recommending that the Treasury brings investment consultants within the FCA’s regulatory perimeter
- Recommending the removal of barriers to the pooling of pension scheme assets
- Launching a separate market study into platforms, and
- Convening an independent group of relevant stakeholders to develop a standardised template for disclosure of costs and charges to institutional investors
The FCA recognise that some Defined Benefit Schemes may benefit from pooling but that there are barriers restricting this at the moment. Although the removal of these barriers could encourage pooling this will require legislation to be changed and further guidance to be issued to trustees. The FCA agrees that while there are opportunities for pooling it is not necessary to make this mandatory. The FCA will work with the Department of Work and Pensions to take this forward.
What should asset managers do now?
The proposals will have a wide ranging impact on internal governance and in respect of fund development and regulatory and marketing documentation. Firms should consider whether any of the proposals could be usefully included in their ongoing MiFID II and SMCR projects but there are clearly matters which need to be taken into account now in terms of product design and implementation.
It is important that asset managers take the opportunity to respond to the current Consultation Paper (as Eversheds Sutherland will be).
More broadly, the FCA has noted from its market study that there is a ‘possible lack of awareness’ of competition law in some areas of the asset management sector; in particular in relation to how competition law applies to commercial relationships and how firms interact with one another. Asset managers should therefore take this as a reminder of the importance of ensuring the risks of competition law are effectively managed; that they are well in tune with their firm’s adherence to the competition rules; and that competition law is at the heart of their compliance functions.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.