Are fund fees too costly to ignore?

Why isn’t the status quo enough?

Profit-maximising fee models

Management companies – alternative investment fund managers (AIFMs) and undertakings for collective investment in transferable securities (UCITS) – 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 their March 2023 Industry Letter on the 2021 Common Supervisory Action on the supervision of Costs and Fees of UCITS.

This concern arises when the actual fund costs is significantly lower than the fixed total expense ratio (TER). Investment managers and management companies who can negotiate lower fees might keep the difference as profit, without passing any savings onto the fund’s investors. The CBI will likely request further information from the industry around these practices. 

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 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. Its concern was that some investment advisors have greater fees, and greater potential influence on the fund, than the discretionary manager. 

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 packaged retail and insurance-based products key information documents (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. Rather than one number under the total expense ratio (TER) of the fund, there now are more complex disclosures around costs.

For example, the reduction in yield, which a PRIIPs KID represents as a cost, will change as the holding period of the investment changes. With this increased complexity, a reconciliation against the fees in the financial statements becomes more difficult.

Bundled costs  

Research from the European Fund and Management Association (EFAMA) in September 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 intermediary 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 European retail investment strategy, intending to maximise retail investors’ returns. But the proposal’s focus on cost may actually be detrimental to the industry, and to the retail investors it intends to protect.

ESMA’s proposed value benchmarks could result in several thousand products being compared against each other, steering investors to the cheapest funds.  This could negatively impact funds such as European long-term investment funds (ELTIFs), which may balance higher costs with an ability to fulfil the needs and wants of certain investors.

Impact on investors

This move could have a number of negative consequences for retail investors as well:

• They may overlook products that potentially offer greater value.

• They may be pushed into the same type of product due to the cost benchmark, creating concentration risk and leading to unforeseen adverse impacts in a period of market volatility.

• Ultimately they may see a decrease in the diversity, innovation and choice of funds on offer.

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. 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.   

Investors need robust ex-ante information 

ESMA carried out a mystery shopping exercise on the ex-ante cost and charges information retail clients received. Only in about half the cases had this information been provided on paper or another “durable medium”. 

In some cases the information was incomplete, or was provided orally. And sometimes clients only received ex-ante costs and charges in the later stages of their decision process, impairing their ability to make an informed choice.

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 assessment of value which applies in the UK and consider 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.

We are here to help you

PwC’s experts can give you confidence that your fund pricing and fees will remain compliant and competitive.

• We can perform an independent gap analysis of your documented fund pricing and fee structure policy, comparing it to the CBI’s recent findings and expectations, along with the relevant regulatory requirements.

• We can support a peer analysis of your funds’ fee structures and the fee levels, considering similarities and differences with the market across a number of different attributes.

• We can review your reporting structure’s effectiveness in monitoring fund fees and costs, including your periodic or annual review of fees, and your methodology.