Are Fund Fees Too Costly to Ignore?

Fund costs and fees have become a hot topic for ESMA and NCAs in recent years. In this article Ken Owens and Patrick Farrell from PwC examine why the status quo isn't enough, regulators' proposed solutions, developments in the UK market, and key actions business can take today.

Fund costs and fees have become a hot topic for the European Securities and Markets Authority (ESMA) and National Competent Authorities (NCAs) in recent years.

Fund managers and distribution teams have incentives to keep costs competitive. Funds with excessive fees may struggle to generate investor demand, especially if those fees have affected their performance.

With scrutiny of fund costs and fees on the rise, it’s more important than ever for firms to grasp the risks and complexities at play.

Why isn’t the status quo enough?

Profit-maximising fee models

Management companies may not have the same motivation as fund managers to keep costs down. This may lead to profit-maximising fee models, at the expense of underlying investors.

The Central Bank of Ireland (CBI) highlighted its concern with fixed operating expense models in March 2023 Industry Letter on the 2021 Common Supervisory Action on the supervision of Costs and Fees of UCITS.

This issue emerges when the effective expenses of a fund are considerably less than the predetermined total expense ratio (TER). If investment managers can secure reduced fees through negotiation, they may retain the surplus as profit, neglecting to transfer any of the savings to the investors of the fund.

Varied fund operating models

Given the wide variety of fund structures and investment strategies, regulators need to ensure investment managers’ activities are in line with fund prospectuses and regulation.

The results of the CBI’s 2019 Thematic Review of Closet Indexing demonstrated how, for example, some investment managers charged investors for active investment management while passively managing funds.

Non-discretionary investment advisors

More recently, in July 2023, the CBI sent questionnaires to firms with non-discretionary investment advisors appointed to their funds. Given the size of the fees, the CBI wants to clarify if these costs are in investors’ best interest – particularly where the split of fees is greater than 60:40 for the discretionary manager and investment advisor, respectively.

Transparency and reporting complexities

Fund costs and fees must be published in several documents, including PRIIPs KIDs, prospectuses and financial statements.

The recent move from the UCITS KID to the PRIIPs KID was meant to simplify how costs are communicated. But the new reporting brings new challenges with more complex disclosures around costs now required.

Bundled costs 

Research from the European Fund and Management Association (EFAMA) in 2021 found that on average, 41% of the fees UCITS charge cover fund management companies’ expenses in product development and investment management. Another 38% of fees go to distributors for providing advice and acting as intermediaries for retail investors.

In most continental European countries, distribution and advice costs are bundled in the ongoing charges retail investors pay to fund managers, before being retroceded to distributors. The total cost paid by retail investors reflects the total cost of ownership.

Cost bundling makes it easier to see the total amount paid by the client, but more difficult to separate and distinguish different charges along the fund value chain. This creates a problem with cost attribution: it’s not clear how much fund management, distribution and advice are driving costs.

As a result, some market observers can mischaracterise fees retained by fund managers, unaware that a large part of the cost is driven by distributors and advisers.

Regulators’ proposed solutions

Value for money

European legislators have put forward the idea of ‘value for money’ as part of the recent European retail investment strategy, intending to maximise retail investors’ returns. But some industry participants fear that the proposal’s proposed cost benchmarks may actually be detrimental to the industry, and to the retail investors it intends to protect because they may reduce product diversity and stifle future innovation, leading to negative consequences for European investors.

There are concerns in the market that the EU’s plan to introduce costs and performance benchmarks is not as holistic an approach as the FCA’s Value Assessment (AoV) and may mislead investors. There has already been strong pushback against the current benchmark proposals in the European Parliament, and it seems that while the approach is well-intentioned, ESMA’s over-emphasis on cost in its proposals is in stark contrast with the FCA’s framework that considers more fundamental features of investment products.

The next few weeks and months will be crucial in determining how significant this divergence is between both governing bodies.

What’s happening in the UK Market

Assessments of Value (AoV) have been required in the UK funds industry since 2019. Recently, a review of the AoV’s of Authorised Fund Managers (AFMs) conducted by the FCA identified the following issues with the approaches to AOVs taken by some AFMs:

Performance: There is a significant disparity in practice levels when it comes to AFMs assessing their fund performance. Good practices included setting fund objectives and performance thresholds that reflected investment strategies, while weaker practices had a bigger emphasis on capital growth targets that are more easily achievable.

Costs and economies of scale: Certain firms have confused AFM costs with comparable markets rates criteria. Others did not have a detailed costing model or had significant costs allocated on the fund’s relative AuM, leading to a limited ability in analysing costs at a fund and share class level. However, benefits were evidenced in cases where the firm decided on the reinvestment of economies of scale into the firm.

Comparable market rates: Even though there is no prescription of any weighting to specific criteria, the justification of fees with the peer funds comparison does not lead to meaningful compliance with the assessment of value rules.

The AoV will be of increased importance for Irish funds being sold into the UK as we understand that the FCA has been informing  firms selling in EU UCITS in the UK that they should commit to producing value assessments within the next 12 months.

Arguments for a more prescriptive approach

Given the current macroeconomic environment, with high inflation and high interest rates, all market participants will be looking at costs and revenue with increased interest over the next 6 to 12 months.

There is room for improvement without conflating value and cost.  One positive step would be to define the costs which are “undue”, and offer clear guidance to the industry on which costs are appropriate to charge directly to the fund, and which charges should be absorbed by fund managers, AIFMs and fund service providers. Costs that are simply the cost of doing business should not be passed directly onto investors.

Directors must do their part

Some fund managers have become more creative around classifying and recharging fees to funds. Fund directors must remain vigilant and ensure that all fees including any new fees are appropriately challenged, in particular where the fee is being charged to the fund.  

Key Actions Businesses Can Take Today

1. Review fees - Firms need to perform an independent review of fund fees and a gap analysis against the expectations highlighted in the  CBI’s March 2023 “Dear Chair” letter. The CBI expects firms to have a plan in place to address any identified gaps by Q3 2023.

2. Ensure marketing material is clear - All marketing materials and regulatory documents including PRIIPS KIDs, prospectuses must provide consistent fee disclosures to investors in line with the specific regulatory methodologies applicable.

3. Review oversight, reporting and policies - Review governance oversight of fee structures, reporting to the board of directors and policies and procedures in order to ensure that no investors are adversely affected from undue fund costs.

4. Define value for money - Consider the recent proposal from ESMA to create value for money benchmarks and the AoV which applies in the UK. Examine the potential implications for the firm as the direction of travel from regulators points to an increased level of scrutiny around value and defining value for investors.