Once considered to be a safe haven from regulatory scrutiny, the investment management sector is now attracting increased political and regulatory attention due to its growing importance in society.
The value of assets managed by the sector has steadily increased relative to GDP over the past decade. This is due to a shift from bank to capital markets financing along with an increase in costs of asset management driven in part by the last decade of low interest rates. The wealth of the sector has led to regulators focusing more on both the value for money the sector contributes to consumers and on whether they invest in suitable products.
Questions have also been asked whether the sector can cause systemic risks, particularly in view of the size of the largest firms like BlackRock.
Costs in the retail investment management sector
Transparency in costs from fees and charges and associated value for money will continue to be an important topic related to regulatory compliance. In particular, value for money in retail investment products is an overriding theme. The European Union (EU) has translated requirements for new investor disclosure under Markets in Financial Instruments Directive (MiFID) II and packaged retail investment and insurance-based products (PRIIPs), unbundling execution fees under MiFID II, and scrutinizing performance fees and closet indexing. The European Securities and Markets Authority (ESMA) is also assessing retail investment product disclosures. On the other hand, in the UK, the Financial Conduct Authority (FCA) has established new rules for assessing the value of investment funds.
Investment managers will critically scrutinize the value of research they receive but will continue to demand broad coverage. With the implementation of the MiFID II payment for research rules, the European Commission (EC) has called for a study on the impact on research relating to fixed income products and small- and medium‑sized enterprises. Similarly, the FCA is conducting a multi‑firm review on the research market. Besides, the AMF is assessing the impact of the rules as one of its 2018 strategic priorities.
The good news for investors is that MiFID II has led to a large fall in the price of research as investment managers apply greater scrutiny to its value. Regulators are continuing to scrutinize pricing models to ensure that research is not being accepted on terms which could be considered an inducement.
In the context of Brexit, the delegation of investment management functions by Undertakings for Collective Investments in Transferable Securities (UCITS) and Alternative Investment Fund Managers Directive (AIFMD) firms has attracted increased scrutiny by EU regulators. ESMA set out its opinion in 2017 with heightened expectations related to regulatory framework on the reasons revolving around the delegation, the level of resources in the EU, independent oversight of the delegate, and protections for the UCITS funds.
Similarly, FCA disclosed its concerns related to asset management market study about AFMs – i.e. UCITS or AIFMD firms managing authorized investment funds – lacking independence from investment managers to which they delegate. The FCA and ESMA have some common concerns. The FCA is stipulating AFM boards to appoint at least two independent directors and for them to comprise at least 25% of the total board membership starting from September 2019.
The FCA needs AFM boards to assess whether their investment funds provide value for money, which will require them to reach their own, independent conclusion. Finally, the FCA is introducing a prescribed responsibility under the Senior Managers and Certification Regime (SM&CR) for these new obligations starting from December 2019. Overall, the FCA wants AFM boards to become more independent and evidencing robust challenges.
Product governance and distribution
In 2018, leaders of investment services companies started receiving target market data from distributors under the MiFID II product governance rules. To date, they have primarily focused on ensuring they receive the right level of data. However, in 2019, as the quality of the MiFID II target market data received from distributors matures, investment managers will be able to draw out useful commercial insights such as a particular product’s investor base and whether the distribution strategy is appropriate. Many EU regulators have recognized MiFID II inducements rules as a key area of supervisory focus during 2018‑19, emphasizing on whether firms receiving inducements are providing appropriate additional investment services to clients. The Commission has reportedly supported postponing the introduction of the PRIIPs KID regime for UCITS funds from the end of 2019 to the end of 2021. We expect supervisors to continue scrutinizing high‑risk, complex investments. Review by FCA of automated investment services it found failings relating to disclosures, suitability assessments, client information, and vulnerable customers and governance.
The European Systemic Risk Board (ESRB) published recommendations on liquidity and leveraging risks in investment funds, following the Financial Stability Board’s (FSB) work on potential systemic risks. ESMA is also expected to publish its guidance on fund liquidity, stress testing, and leverage limits in 2019. The FCA is consulting on rules to protect retail investors in open‑ended funds investing in illiquid asset management practices. Regulators will increase the scrutiny of fund liquidity management and impose more stringent restrictions on fund leverage, particularly for open‑ended funds investing in illiquid asset management strategies.
In conclusion, firms need to demonstrate strong governance processes, specifically in areas of product design, leverage monitoring, fund stress testing, and establishing contingency plans for stressed market conditions.