MiFID II and the cost of outsourcing to a DFM

As analysts, we are delighted to see the headlines that have reported the passing of the revised Markets in Financial Instruments Directive (MiFID II) into law, which is making it compulsory for UK investment firms to disclose the total cost of their investments to their clients.

How MiFID II will affect advisers

The total cost of investment will need to include adviser cost, product cost, third-party cost, transaction cost and everything else that affects the amount returned to investors.

The cost will need to achieve the twin goals of being stated in a single number as well as being understandable. While this is, on the face of it, eminently sensible, I do not envy the task of bringing all these figures together from different parts of the distribution chain.

Cost transparency

With us having to wait until 2016 for the new rules to be put in place, now seems to be a good time to remind ourselves what costs to the client can be involved in investing in a discretionary service.

Fundamentally, there are two structures. There is the ‘all-in’ fee which includes all transaction charges and often other supplementary administration charges. The other structure is where the annual service fee is for the management of the portfolio only – other charges levied such as transaction fees are charged in addition to that.

We could have a lengthy debate around whether the latter structure is the better one. On the one hand, it is transparent and the client can find out what they are paying for exactly. On the other hand, an accumulation of many small administration charges, in addition to the annual fee, is actually quite difficult to forecast and depends on activity.

All this being said, the headline rate is a good place to start as this is likely to be by far the largest deduction to portfolio value.

Bespoke services

Defaqto has found that the average annual service fee for bespoke services (at £500K) is 0.85%. It can fall as low as 0.25% and rise to 1.5%.

This is quite a disparity no matter whether the fee is ‘all-in’ or not. You would have to look very carefully at the service to see if the client is getting value for money. High charges at £500k may well be a device used by the DFM to avoid that level of business – more than half the bespoke portfolio services operate a structure where the service fee falls (in percentage terms) the higher the level of investment.

Also, about 60% of the bespoke portfolio solutions charge transaction fees on top of the annual service fee

Managed portfolio services

The more commoditised managed portfolio services have an average annual service charge (at £100k) of just over 0.7%, and operates in a similar range of charges to bespoke. Less than 40% of managed portfolio services operate a structure which charge transaction fees in addition to the service fee and only 21% see any reduction in fees (in percentage terms) as amount invested increases.

Hosted on a platform

Headline fees for services hosted on a platform should be significantly less. Custody, trading and many of the administrative functions of the service will be undertaken by the platform.

Average service fee (from the discretionary firm) for a service hosted on a platform (at £100K) is just under 0.4%, ranging from 0.2% right up to 1%. Platform charges should be added to this figure, and average out at 0.3%. However, as with discretionary management you also have to look at any additional administration charges

Other fees

Apart from the headline fees, there are many other charges that can affect the total cost of discretionary management:

• Initial charge – only three solutions make this charge
• Custody charges – only a couple of solutions charge this as an addition
• Performance fees – only one solution charges for this and a couple of others have it as an option open to negotiation
• Underlying collectives. Most discretionary firms should now be using clean share classes at a minimum. Many firms will have the clout to access institutional rates as well. Check the DFM firm's approach here as this could be an area where charges mount up
• Platforms. Similar to above – platforms may have restrictions on which share classes they have access to
• Other administrative charges could include: ad-hoc valuations – most should be free and accessible online, income payments, probate and corporate actions

The key is, as the regulators keep reminding us, that the client should be getting value for money, so knowing where the charging points can occur is fundamental. Equally though, superior service, superior performance and good personal relationships may all be worth paying a little extra for – focus on the headline rates and where charges really can mount up.

For clients who have reasonably significant assets under management, the accumulation of a number of small administration charges is likely to only have a marginal effect on total cost in percentage terms.

We have our fingers crossed that many of these tricky considerations will disappear in 2016, courtesy of MiFID II.