The Challenge

The European Commission launched the EU Retail Investment Strategy (RIS)¹ to increase the protection and participation of retail investors in the capital markets across Europe.

Despite being considered relatively “well-off” by global standards, EU citizens do not invest in securities markets to any great extent for reasons that include the market dominance of banks and the absence of an investment culture and mindset. Some EU statistical data provide stark examples:

• Only 17% of EU household assets were held in financial securities in 2021²
• On average, EU retail investors pay 40% more than institutions to invest³
• 45% of EU investors are not confident that the investment advice they receive from their financial advisors is in their best interest⁴

The Solution

The EU RIS proposes material changes to the foundational regulations such as:

• The Markets in Financial Instruments Directive (MiFID II)
• The Undertaking for Collective Investment in Transferable Securities (UCITS)
• The Alternative Investment Fund Managers Directive (AIFMD)⁵        
• A fundamental revamp of packaged retail and insurance-based investment products (PRIIPs) 

So, it’s a big deal for regulated EU funds overall. The package of proposals considers crucial items such as inducement rules, best interest tests, and revised client categorization definitions.

While there has been overall industry support for EU RIS, cost benchmarks and a narrowly defined “value for money” proposal have caught the attention of the asset management community more than any other topic. Industry believes this disproportionately homes in on costs/price points and sets ESMA as a de facto pricing regulator.

Value For Money  

The supervision of value for money is intended to address concerns that the price of retail funds remains too high. European regulators have recently focused on “undue costs” and “value”, as shown in their reviews of closet tracking funds. The Central Bank of Ireland (CBI) has been particularly vocal on the topic and EU RIS proposals have been heavily influenced by the recent common supervisory actions on undue costs by EU regulators. While the industry broadly acknowledges that the concept of value for money has merit to investors, a prevailing narrow definition which focuses on fund costs might lead to unintended negative consequences.  

Fund Cost Benchmarks

By far the most contentious part of the proposals relate to the suggestion that ESMA be given a mandate to create cost and performance benchmarks of some 30,000 UCITS sub-funds under their supervision. Individual fund manufacturers would need to compare their own funds against the benchmark products and take certain actions should their fund deviate from the benchmark.

Any material deviation from the benchmark would assume the price point of the fund is too high and possibly require the asset manager to suspend new subscriptions to the sub-funds until they have justified the cost deviation. The reputational impact of such deviation could be difficult (if not impossible) to manage.

The primary industry concern of such cost benchmarking is that it could negatively impact product diversity and innovation, taking its biggest toll on smaller funds and asset managers, and possibly resulting in a herding of investors into the lowest cost products such as passive funds. There is initial skepticism about whether cost benchmarks can ever appropriately reflect the diversity of investment strategies across a wide spectrum available in the market currently.

All this focus on “undue costs” also comes at a time where data shows that average ongoing charges for UCITS funds have been steadily falling since 2013⁶. Industry also contends that such a benchmark would disproportionately focus on costs to the exclusion of value or desired outcomes. More broadly, many in the industry believe the proposals are premised on UCITS funds being homogenous, when in reality, this is not the case.    

UCITS currently provide retail investors with a raft of investment diversification opportunities for many disparate asset classes, industries, and geographies. Bond funds tend to be cheaper than equity funds and emerging market or small cap equity portfolios generally are more expensive than large cap equity funds. The reasons for fund cost differentials are relatively well known and disclosed. They can vary depending on asset classes, distribution models, geographic focus, and a host of other factors.

At Odds with UCITS?

Setting a midpoint UCITS fund cost benchmark appears to disregard the fact that the market is in fact quite heterogenous in terms of differing types and sizes of funds. The fact that there is not a “template UCITS fund” makes it extremely difficult to construct a precise and fully representative benchmark across the spectrum of UCITS funds. One of the beauties of the UCITS regime is that it houses a wide spectrum of investment strategies within a single pan-EU governance regime.

The initial suggestion seems a very blunt mechanism premised on a single correct price for a UCITS against which all other funds should be required under regulation to calibrate themselves instead of leaving pricing to competition and market forces.

Costs are a really important element in any value assessment, but they aren’t the only element to consider. Factors such as investment performance, diversification, the overall investment objective, the condition of the retail investor, and the quality of service to be provided are all considered in a holistic assessment of product “value”. Industry debate will continue to focus on whether cost benchmarks will help or hinder investment choice and whether ESMA has overstepped its investor protection mandate to become a de facto pricing regulator for the asset management industry. One thing is for sure, the EU RIS cost benchmarking proposals have set tongues wagging.

For more information, please contact Adrian and read his article on the latest UCITS revisions.

The views and opinions expressed are for informational purposes only and do not constitute investment advice and are not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Views and opinions are current as of the date of the publication and may be subject to change.