Regulators are finally forcing the financial industry to be more transparent about costs. But it’s not all good news, says Merryn Somerset Webb.
If you work in finance or live with anyone who does, you will have heard of Mifid II. However, you won’t know that when it was first discussed, it was sometimes said without a swear word in front of it. That doesn’t happen much any more.
The Markets in Financial Instruments Directive II (which builds on the early 2000s introduction of the first Mifid), is a set of EU-wide rules designed to do the kind of good things no one could possibly disapprove of – to make all distribution of and trading in financial products as transparent and cost-effective as possible. You will think that we approve. After all, at MoneyWeek, we have spent much of the past 18 years lobbying one way or another for exactly this. And indeed we do approve – in theory.
The problem is that the final documentation for Mifid II runs to 1.4 million paragraphs. That’s more than even the most dedicated compliance officer will ever really read. Worse, its introduction has come at the same time as new regulations on investments known as Packaged Retail Investment and Insurance Products (Priips). These are also designed to make the costs and benefits of the likes of investment trusts and exchange-traded funds (ETFs) clearer to buyers. The two groups of regulations are hugely well meaning. But add it all up, and I think we all know that with them will come costs, complications, unintended side-effects and, worst of all, an awful lot of admin for someone (some trades require managers to fill in 65 fields of information almost immediately – hence the swear words).
So what does it mean for you? There’s much in it that the ordinary investor really doesn’t have to worry about yet (we can’t be sure what the long-term impact will be). But there are also a few issues arising from January’s bureaucratic bonanza that we should at least be aware of.
The competition killer
In the past, stockbrokers have provided their analytical work “free” to fund managers, but snuck the cost into the trading commissions they charge back to clients – something that will no doubt come as a surprise to anyone under the impression that their fees paid for the fund-management industry to finance its own research. This isn’t going to be allowed any more. Instead, anyone who provides research has to charge for it explicitly. And anyone who pays for it and then passes that cost on to their clients will have to tell them about it.
The initial results of this are pretty clear. Very few fund managers have had the brass to say they are passing on the costs – they are going to have to pay from their take (as they always should have). That means they are looking at what they want (and in the case of small managers, what they can afford). The answer, in all cases, is less than before (it’s amazing how little of a thing you need when
you aren’t paying for it with other people’s money). As a result, much less will now be spent on research (one consultancy forecasts a total fall of about $1.5bn a year from today’s $5bn-odd), mediocre analysts will fall by the wayside, and star analysts will badger their employers (rightly) for a bigger cut of their newly established price.
The longer-term effects are less clear. The big banks may start competing with the independent research houses, pushing down prices across the board. The big fund managers – who can afford to buy all the research they like – may find they have a huge knowledge advantage over small houses and start-ups, a competition killer that won’t be quite what our enthusiastic bureaucrats intended. And the amount of information available overall may fall – particularly in areas that it is harder to get paid-for research on, such as small caps. That could mean less liquidity and more volatility – and, in good news, more opportunities for clever stockpickers.
The dodgy performance numbers
The Priips rules require providers to produce a new key information document (Kid) for their investors. The idea is to help them understand and easily compare the risks, rewards and costs of different investment products. You will think that this makes sense – and in theory at least, so do I. The inability to compare products has been one of the many things dumbfounding investors for decades. The problem? It’s really hard to find a standardised way to compare very different types of products. So the new Kids are horrible documents, as John Kay explains in the Financial Times.
He had originally assumed the whole thing was simply another bit of trying “bureaucratese” that “could be delegated to the competent people who spare the rest of us from the burden of regulatory compliance”. Not so. Turn to the Scottish Mortgage Kid (Kay is a non-executive director of the investment trust), look at the “what you might expect” section, and you will see something unexpected – a suggestion that in a favourable scenario, investors could expect to see an annual return of 30% over five years, but that even in an unfavourable one they could expect an annual return of 10%. Only in a “stress” scenario does the document suggest anyone might lose money.
This is not the kind of promise anyone could or would make. Scottish Mortgage (Smit) has done well (see page 22), but it won’t do so forever. So why the crazy optimism? All Kids have to be written to a prescribed formula using the key concept of value-at-risk-equivalent volatility (Vev). There is no need to understand anything about this except that it effectively extrapolates the relatively recent past (ie, a strong and fairly consistent bull market) far into the future. This makes Smit look good and some other funds look insanely good – as Chris Flood points out, also in the FT, some very short-term investment products end up looking as though they generate annualised returns of “more than one million per cent under the approved calculation”.
This is a “triumph of pseudoscience over common sense”, says Kay. But it’s more than just that. It is also a reversal of many years of work to prevent fund managers from pretending that past performance is a guide to the future (when it isn’t, particularly in most of the fund-management industry) – and a mis-selling nightmare in the making. So when you check your Kids, approach the performance section with caution.
Off limits from now on
Then there are the funds that you may not be able to buy ever again as a result of all this. Most EU-based funds have produced the new Kids by now. However, hundreds of US-domiciled ETFs and closed-end funds (the American equivalent of investment trusts) have not. Until they do, you can’t buy them. And they probably won’t.
So these funds will be out of reach for most individual investors. The only exception – at least for the time being – may be if you can qualify as a wealthy or sophisticated investor and your broker allows investors who meet the criteria to deal in these funds. Even so, there’s no guarantee that the regulator will allow firms to take this approach.
The coming battle with your fund manager
One of the ideas behind the new rules is that fund managers have to spell out how much they charge you. So you will no longer see your charges as an ad valorem amount (0.75% perhaps), but as a sum that includes all the extras – from transaction costs to research costs. Once again, however, the new situation isn’t 100% satisfactory. First, it doesn’t affect the most common investments in the UK equally (UCITS funds are not yet included). Second, the attempt to standardise brings subjectivity.
The new number includes transaction costs (quite right – trading costs really matter), but also an estimate of “market impact” – how much the trade itself moves the market. So funds dealing in illiquid assets will end up looking far more expensive than those that do not (regardless of how much managers and brokers charge). This is fine. But it does mean that investors will have to remember that different funds do different things and to consider their overall costs in that light – and that providers might have to make more effort to explain how their costs add up and why they feel they are justified.
So will the end result for you be good or bad? It’s too early to say. But transparency often reduces costs. So it’s perfectly reasonable to hope that it will add to existing pressure on fund managers to think a lot more about price than they do at the moment. That said, implementing the new rules has also been expensive for companies, and will continue to be. Someone has to pay for that – we will want to see it come out of asset-manager margins, they will want to see it come out of our returns. This battle has some way to play out.