Value for Money Assessment in Europe. Can we Trust the Gatekeepers?
- The rules introducing the value for money assessment in Europe will shift the onus on fund management companies to make sure that UCITS and AIFs do not charge undue costs and offer returns for the investment of retail investors.
- Value for money assessments already exist both in the USA and in the UK. In the USA they allow to evaluate the trustworthiness of investment advisors. In the UK, similarly to Europe, the main aim is retail investor protection.
- There is a risk of conflict of interests in the professional fund management industry due to the new rules. Whilst fund management companies have commercial relationships with promoters of the third-party funds they manage, they will also have to gatekeep from coming to market inefficiently managed funds.
As the pace slows down on SFDR implementation and ESG revolution in Europe, market participants are bracing together again in preparation of the soon to be introduced value for money assessment under the Retail Investment Strategy. In a bid to increase exposure of European households and retail investors to capital markets, the forthcoming rules will impose new product governance obligations also on fund management companies.
In one with creating new governance and operational challenges, linked to the establishment of a well-documented pricing process and the carrying out of yearly assessments on the pricing of investment funds, the value for money assessment will undoubtedly have broader implications for the fund management ecosystem as it stands today in Europe.
With potentially less launches and corresponding more closures looming, the new rules will likely have also second step implications for the highly concentrated independent/third party fund management industry in Europe.
History of the Value for Money Assessment and Comparison with Other Regimes
Pricing assessments of investment funds as a practice are not entirely new to the global fund industry. A similar assessment was introduced for the first time in the UK in 2019, following a broad review of the market for asset management services. And a periodical assessment of the costs charged by investment advisors exists also in the United States of America. This is where the so-called Gartenberg principles were minted. Though in the United States these yearly exercises are staged in the context of the renewal of investment advisory contracts and are essentially used to test the trustworthiness of advisors. They benefit investors only indirectly or else retail investor protection is not at their core.
The UK version of the assessment is morphed on the model existing in the United States. That is namely for what concerns the introduction of an additional layer of governance, with independent directors called to ensure accurate and independent results of these yearly price evaluation processes. However, the rationale for this assessment in the UK, much more similarly to Europe, lies exclusively in protecting retail investors and ascertain whether the investment funds they can access offer them value. Where Europe did not introduce specifically the requirement to involve independent figures in the value for money assessment process, as it is the case in the US and in the UK, it went a step further by requiring that assessments be carried out separately both by product manufacturers and distributors. In this article we have restricted the analysis to the product governance rules introduced for UCITS management companies and AIFMs as product manufacturers.
The new product governance rules also close the circle on another recent debate on undue costs charged by UCITS and AIFs. The new rules receive the suggestions made by ESMA in the latest proposal on undue costs for UCITS and AIFs dated May 2023. Following the Common Supervisory Action commenced in 2021 on the supervision of costs and fees of UCITS and AIFs across Europe, ESMA proposed to introduce under the respective directives the notion of undue costs, in one with an obligation for UCITS management companies and AIFMs alike to prevent that investors in UCITS and AIFs are charged undue costs.
New Obligations on Management Companies
As proposed by ESMA, the new product governance rules introduced under the Retail Investment Strategy via an Omnibus Directive attempt to define the concept of undue costs. They also introduce specific obligations on both UCITS management companies and AIFMs to prevent undue costs from being charged to funds and its investors as well as a robust pricing process for the quantification of fund costs. As also hinted under the ESMA opinion on undue costs for UCITS and AIFs, the notion of due costs will be anchored to the cost structure introduced under the PRIIPs regulation.
Whilst the bulk of the details will come in second level regulation, like minimum requirements for the pricing process structure as well as the criteria to determine whether costs charged are justified and proportionate, the current version of the Omnibus Directive is clear enough on the broad range of the new obligations imposed on UCITS management companies and AIFMs, which cover the areas listed below.
UCITS management companies and AIFMs shall maintain, operate and review a clearly documented pricing process that enables them to identify and quantify all costs that are charged to funds and their investors. The pricing process will be applicable both to funds that are in the process of being launched and to the ones that are in existence already.
The value for money assessment shall be performed yearly, to ensure that costs charged to funds and their investors are not undue or charged in an unjustified and disproportionate manner. The assessment shall require that costs are correctly identified and quantified and that potential conflicts of interest and related risks are mitigated.
Reporting to competent authorities, depositary and auditors is imposed on UCITS management companies and AIFMs in all instances where undue costs have been charged to funds and its investors.
Member states will make sure that UCITS management companies and AIFMs are responsible for both effectiveness and quality of their pricing process. UCITS management companies and AIFMs shall also reimburse investors where undue costs have been charged to funds and their investors.
The issue of Benchmarks and the Comparison with Market Standards
One of the most controversial aspects under the new product governance rules relates to the introduction of so-called benchmarks. Official industry benchmarks will be produced by ESMA and the other European Supervisory Authorities (ESAs) to assist with the pricing and cost evaluation carried out by UCITS management companies and AIFMs. Considering that the value for money assessment is essentially aimed at offering protection to retail investors, the use of benchmarks for comparative purposes is not imposed as part of the pricing review for AIFs dedicated to professional investors only.
To facilitate the task of the European supervisory authorities in the creation of benchmarks, without introducing completely new additional reporting requirements, product manufacturers will likely provide ESMA and the other ESAs with the data on costs and performance in the same standardised format provided already to their distributors. It seems unequivocally clear from the provisions contained in the new product governance rules that there will be no active monitoring as such carried out by the European authorities themselves. The obligation to assess that costs and performance are in line with market standards will be entirely on UCITS management companies or AIFMs as well as distributors.
At this point we can only speculate about the design of the benchmarks. The specifics will come in with the second level regulation accompanying the Omnibus Directive. However, one can assume that benchmarks will be organised per sector and type of product. Like a benchmark for bond funds and for the various strategies and styles under that main segment, for instance. The same should be for equity funds. For what concerns the cost and performance ranges, we could assume that these will be organised in a clear-cut dichotomy – acceptable vs. unacceptable. It cannot be excluded though that there could also be other variations, including a version with an intermediate range for funds that need closer monitoring but do not need to be removed from the market yet. ESG remains still an incognita and we cannot say whether the main segments for benchmarks will also have an ESG variant or not.
A more Selective Fund Market in Europe
There are of course naysayers and detractors for each and any European initiative in the space of financial services regulation. For what concerns the value for money assessment, the main criticism is around the fact that there is already an element of pricing evaluation with the PRIIPs regulation and a second one is not required. In one with performance scenarios, the PRIIPs regulation realistically did introduce a clearer indication of the costs of an investment over the course of set holding periods. And where we may agree that the list of costs under PRIIPs is indeed the baseline to carry out the pricing assessment exercise under the value for money assessment, there is so much more to the spirit of this assessment compared to the rules under the PRIIPs regulation.
Suffice to say at this stage that there are inherent limitations in the PRIIPs approach on costs. That is for various reasons. On the one hand, the PRIIPs regulation was introduced to create a standard disclosure that could assist retail investors when choosing amongst different investment products. On the other, so far the information contained in the PRIIPs have not been used by the authorities of all member states because not all of them require that the PRIIPs KIDs are notified to them before products are made available to investors.
Whilst essentially aimed at helping retail investors as well, the Retail Investment Strategy goes in a completely different direction. The new initiative of the European Commission wants to elevate the standards in the European market so that only funds that offer value for money can be presented to retail investors. An active filter based on costs will be applied going forward to scrutinize investment funds that want to go to market for the first time same as the ones that have been on the market already. It seems clear how European authorities are envisioning the market having to evolve based on more selective standards, rather than having national supervisory authorities taking on the additional burden of price regulators.
For the pricing process being applicable also to funds that are at the authorisation stage, we believe it inevitable that going forward many more funds will likely not be authorised and launched. In addition to that, there will also inevitably be funds that will be removed from the market for them being too expensive.
Can we Trust the Gatekeepers?
For the implications of the new value for money assessment to be evaluated to their full extent, it makes sense to put the new rules in the context of the fund management business in Europe as it developed over the course of the past decade.
With the introduction of AIFMD in 2011 we have witnessed a trend of professional or independent management companies mushrooming across Europe. We define them professional because they do not have proprietary fund products. Rather they offer risk, portfolio management and other services to third party promoters or initiators when launching their own funds. For the past five years or so, there has been M&A activity at an incessant pace in this sector, resulting in a handful of big conglomerates offering specialised fund management services in both Ireland and Luxembourg. There are of course positive and not so positive consequences resulting from the consolidation. Big fund management companies can offer expertise and economies of scale to their clients, making the management of their funds safer and more efficient. On the flipside, concentration and other system risks of sort are part and parcel of vast consolidation phenomena.
For what concerns specifically the value for money assessment, the issue is one of conflict of interest. It seems clear that the vision of European authorities is that these big fund management companies will also play the role of gatekeepers to the fund market going forward. This is why the onus has been shifted on the management companies to make sure that only the best and most cost-efficient funds can come to the retail market. However, professional fund management companies have a commercial relationship with the promoters of the fund launched under their supervision and accordingly profit also on the number of funds they provide their services too. Whether we can trust the gatekeepers is a legitimate question.
The new product governance rules seem to be designed to leave little room for ambiguity in that ensuring fair pricing of funds becomes another duty of management companies with repercussions on themselves first. Also, in addition to the European wide regulation, pressure on the excessive cost profile of certain funds – that have little to no perspective of returns for their investors – had been previously exerted publicly by local regulators in very respected European domiciles. Anecdotal evidence shows us also that, notwithstanding commercial relationships, the issue of costs and performance is already discussed by independent management companies for the funds of their clients.