Spotlight on Retail Fund Costs and Fees

With an increased focus at both an Irish and European level on costs and fees in retail funds, Jennifer Fox (Walkers), provides an overview of the regulatory developments on this topic and the key considerations for fund managers

The last number of years has seen an increased focus at both an Irish and European level on costs and fees in retail funds. 2021 saw the launch of ESMA's common supervisory action ("CSA") with EU national regulators focusing on undue costs in retail funds. As part of the CSA, the Central Bank issued a questionnaire on fund costs and fees to in-scope management companies and self-managed funds ("Questionnaire"). Separately in April 2021, the Central Bank updated its guidance on performance fees which effectively endorsed ESMA's performance fee guidelines. More recently ESMA also updated its Questions and Answers on the application of the UCITS Directive ("Q & A") to provide clarification on investor rebates and fee arrangements.

A common theme that has emerged from these regulatory reviews is the importance for fund management companies (including self-managed funds) ("Managers") of ensuring that the fees charged to funds are appropriate in the context of the fund's targeted return. Transparency of fee disclosures is also a key consideration in respect of both new and existing funds.

We have explored below what Managers can learn from these regulatory developments and how best practice is likely to evolve.

The Concept of Undue Costs – ESMA's Supervisory Briefing

Prior to the CSA, ESMA published a supervisory briefing on the supervision of costs in UCITS and AIFs. This briefing was a milestone as it set down common guiding principles which Managers should consider when assessing the concept of undue costs. While there is already a regulatory obligation under both the UCITS and AIFMD frameworks for Managers to prevent undue costs being charged to a fund and its investors, ESMA identified divergent interpretations of the notion of "undue costs" and different supervisory approaches to cost-related provisions across EU member states. In this briefing ESMA emphasised the importance of a common framework for national regulators to consider in their supervisory activity when assessing the level of funds' costs and noted that the aim of the briefing is to assist EU regulators with this assessment.

What are these Common Principles?

The overarching consideration identified by ESMA is the obligation to act in the best interests of investors. Key to this is the idea that all fees and other fund costs are transparent and easily understood by investors. Investors should be able to clearly determine the fees payable to a fund’s service providers and the level of costs that a fund is likely to incur.

Pricing Policies for Managers

• In order to be a position to identify and effectively supervise undue costs, ESMA recommends that Managers implement a pricing policy dealing with, inter alia, the following key elements:

• whether the costs are proportionate compared to market standards and to the type of service provided;

• whether the costs borne by the fund are sustainable;

• whether the costs ensure investors’ equal treatment (except where specifically permitted);

• confirmation of the absence of duplication of costs;

• the proper disclosure and application of fee caps;

• compliance of any performance fees charged with applicable regulations/rules and disclosures; and

• whether the fee structure is consistent with the characteristics of the fund.

Rebate Arrangements and Fee Discounts

Continuing on this theme, the update to the Q & A issued in December 2021 clarifies that management fee discount arrangements and fee rebates paid out of a Manager's own resources are subject to the UCITS rules on inducements. Although not specifically stated in its Q & A, the implication is that these rules will also apply to fee rebates or discounts provided by a delegate investment manager.

ESMA's expectations around fee rebates and discounts can broadly be summarised as follows:

• the arrangement should be transparent;

• the Manager should be able to demonstrate that the arrangement enhances the quality of service to the UCITS and not simply to those investors who benefit; and

• it does not impair with the Manager’s duty to act in the best interests of the UCITS.

An overarching principle is that Managers are bound to treat all investors fairly, act in the best interest of the investors and to refrain from placing the interest of any group of investors above others. Significantly, ESMA states in the Q & A that Managers should be able to provide accurate and documented justifications for applying fee rebates upon a request by a national competent authority.

Central Bank's Focus on Fees and Costs

In line with the CSA, two areas of focus in the Questionnaire issued last year were: (i) the process around setting and reviewing fees; and (ii) the governance and control mechanisms in place in respect of the pricing process. The Questionnaire required Managers to justify the level of ongoing charges charged to the fund and its investors compared to the level of activity against the fund's reference benchmark. In the Questionnaire, the Central Bank also sought information on unified fee structures and fee caps and revenues retained by fund service providers arising from the use of stock lending and other efficient portfolio management techniques.

Amended Performance Fee Guidance

The Central Bank has also focused on significantly increasing transparency on performance fee arrangements and ensuring compliance with existing rules. As set out above, the Central Bank updated its guidance on performance fees of UCITS and certain types of retail investor AIFs which effectively endorses ESMA’s guidelines and to the extent possible incorporates these guidelines into the Central Bank's regulatory framework. This guidance addresses a number of topics including calculation methodology, annual crystallisation, negative performance recovery and disclosure of practical worked examples. In addition, the Central Bank updated its UCITS and AIFMD Q&As in December 2021 and set out its expectations in terms of the multi-manager funds bringing their performance fee methodologies in line with the July 2021 updates to the Q & A on this issue by 1 January 2023. While many Managers of retail funds which charge performance fees will likely already have undertaken an analysis of the guidance against their performance fee policies, procedures and processes, it may be useful for those with existing funds to conduct a further review/check in following the practical implementation date of these requirements to ensure no further amendments are required to the relevant policies, procedures and processes.

Next Steps

In light of the recent regulatory reviews and continued regulatory focus on fee practices, it would be prudent for Managers to implement a comprehensive pricing policy. The pricing policy should address the launch of new fund products, making material changes to fund documents, assessment of investor complaints and review of fund costs on an ongoing basis. Appropriate identification and quantification of costs and assessment that they are fair, reasonable and appropriate as measured against the indicators set out by ESMA in the supervisory briefing would also be expected. It would also be prudent for a pricing policy to address fee rebates and discounts and to include a robust documented justification for any fee rebate arrangements in line with ESMA's recommendations.

It is anticipated that ESMA will present the results of the CSA in the coming months and on the basis of the approach taken by the Central Bank in respect of previous CSAs we expect findings from the responses received to the Questionnaire and follow up work to be published by the Central Bank together with guidance and/or recommendations for Managers to consider and if necessary, take action on.

Jennifer Fox, Partner, Walkers

Contributor Profile

Jennifer Fox is based in Walkers' Ireland office where she is a partner in the Global Investment Funds Group. Jennifer has several years' experience practising as an investment funds lawyer. She acts for a range of funds, fund sponsors and service providers and has extensive experience in advising on the authorisation, distribution and operation of all types of Irish investment funds including UCITS and AIFs.