MiFID II: the gaps in transparency to look out for

Do you believe that MiFID II will result in a level playing field when it comes to the reporting of investment management costs?

While the regulations are a step forward in terms of disclosure, investment managers are still not required to disclose the total costs of their clients’ portfolios. Within the industry, there continues to be a gap between those who declare what is required by the letter of the rules, and those who go further and try to adhere to the ‘spirit’ of what MiFID II is about.

Pricing transparency lobby groups have sprung up and a handful of investment managers are leading the charge with full disclosure. Unfortunately, they often have to caveat their pricing quotations with warnings that they may appear more expensive than competitors and some even provide a “MIFID II price” for comparison purposes, inviting the prospective client to inspect differences between the two.

And while the ‘gap’ between those in favour of full transparency and those wishing to obfuscate is getting smaller, it doesn’t make those adopting opaque practices any more right than they have ever been. Indeed, some of the leading elements of the investment industry lobbied against greater transparency, which should worry us all. I, for one, would not appoint a manager who wasn’t aiming for total transparency. Could I trust someone who couldn’t bring themselves to be as transparent as possible? I think not.

Let us consider some of the gaps between the spirit and the letter of the latest MiFiD II regulations that should be considered when researching investment managers.

Opaque practices

Most portfolios invest in some funds that are not managed by their appointed manager. These ‘third party’ funds can bring significant diversification benefits, both in terms of exposure to additional managers and different asset classes. However, they also have embedded costs. And for the first time, MiFiD II will require these costs to be declared.

However, the regulations only say that managers need to declare the costs of the ‘open-ended’ funds they own and not of ‘closed-end’ investment trusts. Looking out for the vehicle and structure used is important because one could compare two remarkably similar investment portfolios, with 25% invested in third party funds, but the manager using investment trusts could report costs 25% lower than the other: it is unlikely that this is well understood outside the industry.

Moreover, while investment managers have to declare the investment management fees within open-ended third party funds, they don’t have to include the full costs of owning these funds. The ‘other’ charges embedded in OEICs and Unit Trusts can increase the costs
of these funds by a third. Operating within the letter of the law could hide about 8% of your costs.

The way in which your investment strategy is implemented is important and accounts for another possible missing element: VAT. Specifically, the VAT levied on investment management fees applied to segregated portfolios does not have to be declared. This can make a segregated service look inaccurately cheap when compared to portfolios invested in most pooled funds, within which HMRC does not levy VAT on investment management fees. On a £5 million portfolio being charged 0.60%, this could amount to a 12% cost differential.

Lastly, even the more transparent manager will acknowledge that there are still a few areas where more forensic research is required: the costs of trading (the bid-offer spread leakage) and the costs associated with currency hedging. However, even the most transparent investment managers find these hard to monitor and even fewer have the ability to report on them consistently. Other issues surround how initial, exit and performance fees are factored into cost disclosures. The latter will only ever be known after it has been earned while the calculation of the impact of entry/exit fees requires some assumptions as to the holding period over which one amortises these costs.

Caveat emptor!

So no one is perfect and a full analysis of costs will only ever be available after the event. In this, MiFID II is helpful. As well as requiring fuller declarations at the time of an appointment, from the end of 2018, managers will have to supply their clients with an historic analysis of the previous year’s costs. While there will be differences, it is the degree of disclosure (as set out above). MiFID II should be seen as progressive regulation insomuch that it moves the industry in the right direction. However, the playing field is still not level: investors must be as careful as ever when making their investment decisions as small basis point differences can have a profound impact on performance over the longer term.

Richard Maitland is the head of charities at Sarasin & Partners

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