What advisers should have learned about MiFID II so far

10 March 2020

As 2020 has begun we are all preparing for Boris’s Brexit Express to leave the station and take the UK on a journey into the unknown.

This article was originally published in the FTAdviser.

Paul Tinkler, Insight Development Manager

We can only guess at the potential impact of leaving the EU, on various aspects of life in the UK and especially those areas, that are influenced by EU founded legislation and regulation.

Regulation of that type has and does, play a key part in forming the financial services landscape in the UK, as we know it today.  

Most recently the industry has felt the effects of the Markets in Financial Instruments Directive II (Mifid II) - the follow-up to Mifid version I.

Version I came into being in 2007 and was created to increase pre and post-sale transparency and standardise regulatory disclosures in specific product areas, such as investment funds, across EU member states.

Mifid aims

In the UK, there is a view that we were already ahead of the curve, with existing regulation in place related to fee and commission disclosure.  

The popularity and independence of competing platforms also provided transparency, which did not exist in other European states.

Mifid was primarily targeted at other EU markets that were dominated by banks and insurance companies, which operated on an opaque basis, compared to the majority of UK investment and advice businesses.  

We were simply being swept along with the rest of the Community.

As we know, first-draft regulation is rarely perfect, and that was the case with Mifid I. 

In hindsight, it was too inward looking and allowed companies from outside the EU to gain competitive advantages in certain areas.

Mifid II objectives

So, fast forward 11 years to Mifid II, which has been with us since January 2018 and focused upon the following European Commission objectives:

  • Strengthen investor protection, through appropriateness and suitability testing and improved record-keeping, together with more detailed reporting.
  • Reduce the risks of a disorderly markets
  • Increase the efficiency of financial markets and reduce unnecessary costs for participants, through increased transparency of costs
  • Standardise practices across the EU
  • Restore confidence in the industry

In terms of scope, the regulations apply to those firms that provide investment services. 

These include investment/financial advisers in addition to those that manufacture and distribute financial instruments, such as fund managers.

Product-wise, it covers unit trusts, Oeic’s, investment trusts, ETFs and discretionary portfolios, which means it has an impact upon investment advisers, fund managers, discretionary fund managers and platforms.

From all of the above, I would think that ‘reporting’ and ‘increased transparency of costs’ have probably received the most attention in the UK advice market.

Portfolio reporting

We should all now be comfortable with the requirement for portfolio declines of 10 per cent or more, over a quarterly reporting period, to be communicated to clients. 

However, confusion initially occurred around what constitutes a portfolio and who has the reporting responsibility. 

At Defaqto we had conversations, in the early days, with discretionary fund managers (DFMs) and platform providers who declared that Mifid II would have no impact upon them. 

But over the last two years, I think most protagonists have come up to speed in supporting advisers with the regulatory requirements.

From a platform perspective, it may have been true that there was no actual regulatory requirement for them to report DFM managed portfolio falls. 

But because they sit in between the DFM’s and the clients, they were, and are, the only ones who have the capability to effectively and efficiently produce the required reporting. 

This occurs because trades between themselves and DFM’s, operating model portfolios, trade using ‘omnibus’ accounts, which means all the client trades, be those sales or purchases, for a period (normally one day) are combined. 

So a DFM could see one trade of say £1m, but that could be made up of 50 client transactions, none of which would be associated with specific clients. 

 This means the DFM couldn’t have sight of individual client portfolios and therefore identify individual portfolio declines of 10 per cent or more.

An adviser using a platform could indeed identify the clients with relevant portfolio falls, but that’s assuming they can establish suitable alerts within the platform to do this.

The best option was clearly for the platforms themselves to provide this service and the majority now do this.

There was also some initial concern related to ‘advised’ portfolios and that the 10 per cent rule would also apply to those. 

However, I think the industry is now clear that these are simply seen as a selection of funds recommended by an adviser and held by a client. 

These may be described as portfolios, but because there is no discretionary management, they are not caught by the requirement.

Cost transparency

Increased transparency of costs was the other big area for advisers and Mifid II has felt strange from a regulatory perspective, in that the majority of advisers did not comply from day one and many still do not.  

It’s also true to say that many providers, such as fund managers, were also slow to comply, which had the knock-on effect of making it impossible for advisers to communicate the required costs to their clients.

Defaqto was up and running from the beginning, providing the required fees through its adviser software. 

But market coverage was roughly around 70 per cent in the beginning, meaning roughly 30 per cent of the industry was not providing the required data which made the adviser’s task impossible.

A variety of new fee jargon has also come into play, with the likes of ex-ante, ex-post and transaction costs being required.

Two years down the line, it feels like the majority of the industry is up to speed and plain English is winning. 

Ex-ante is now 'estimated' and ex-post is described as 'actual'. Both are much easier for clients to digest.

Transaction costs, a new fee disclosure, which advisers and providers are required to make has also been interesting. 

I think there was some initial confusion around the ongoing charge figure (OCF) including or excluding transaction costs. 

I hope this confusion has now gone away. All should be clear that the OCF does not include transaction costs and that both need to be provided to clients.

With that clarified, the additional confusion of negative transaction costs has needed some work, when it comes to communicating with clients. 

How can a fund have negative transaction costs of say, 1 per cent?

I won’t patronise readers by going through the detail but it’s all to do with ‘slippage’ costs (another new bit of jargon) and the process a fund managers goes through in pricing trades. 

The movement of the price during the trade can result in positive or negative slippage costs. 

As a part of this process, we also get introduced to different pricing methods (more jargon coming up) including ‘arrival’, ‘opening’ and ‘closing’ pricing methods.

Client disclosure

So, where are we today in terms of what needs to be disclosed to clients?  

I’ll end this piece with a brief summary of what advisers need to be telling clients and should have been doing since the beginning of 2018, although virtually no one was.

Pre-sale reporting:

  • Product (fund), service (DFM, Platform, Isa) and adviser costs need to be aggregated in annualised percentage terms as well as pounds and pence, based upon the proposed investment
  • Cost and charging information needs to be given to the client in ‘good time’ before they provide the relevant service to the client
  • One-off costs (entry and/or exit, for example)
  • Ongoing costs (OCF)
  • Transaction costs
  • Incidental costs, including performance fees
  • Total fees related to funds should be quoted as ‘estimated’ (ex-ante) and include:
  • If more than one fund is being recommended then the above fees should be provided at both an individual fund level and aggregated to illustrate the total recommendation.

Post-sale reporting:

Ongoing reporting is a bit more detailed, as one might expect, and should cover the following:

  • The total fees should be reported once per annum
  • The fees are those detailed as part of the pre-sale reporting, based on a client’s portfolio, on an ‘actual’ (ex-post) basis
  • These should be provided in percentage terms as well as pounds and pence
  • Reports can be sent to all clients at the same time ‘bulk’ or on an individual basis
  • There's a requirement to report a 10 per cent drop in performance and multiples of 10 per cent in the quarterly reporting period by end of the business day - only for discretionary portfolios

Looking ahead, it is by no means clear as to our ongoing adherence to EU regulation once we actually depart the Union. 

But UK financial services regulators have clearly stated that there will be no immediate disruption and no thought of tearing up the current directives and replacing them with something else, anytime soon.  

For an industry that often feels under constant regulatory bombardment, this is probably good news – a little bit of breathing space for us all to get comfortable with Mifid II and all that it demands.

Mifid III anyone?

Want to know more?

Watch our MiFID II webinar now to hear about the purpose and scope of this legislative framework.We have extended the capability of Engage, our end-to-end financial planning software, with the addition of in-depth MiFID II portfolio cost analysis functionality. You can read about it here.

You might be interested in other Insight articles.

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