Will Cost Disclosure Be The 'Halloween' of MiFID II ?

Just when wealth managers thought that they could draw a sigh of relief, knowing that their MiFID II obligations were, if not a thing of the past, at least a part of business, as usual, a sense of foreboding is once again creeping into the collective consciousness of wealth management firms. The European Union’s consumer protection regulation has radically changed the way costs and charges are presented for funds and this may well prove to be the most alarming element of the entire MiFID manifesto. January 2019 is the month set for the first annual report for ex-post costs and charges disclosure, covering trades occurring in 2018.

What does Cost Disclosure mean for Wealth Management Firms?

All wealth management firms, no matter how big or small will have to disclose every single cost and charge that they pass on to their end client. From a wealth manager’s perspective, this means that they will have to capture a whole host of data (some of which they will already have). There are some items such as product costs that are wrapped in a price from a broker that now have to be separated out into the cost of the security, market charges, foreign dealing charges, commission and so on. These will have to be itemised and passed on to the client.

Impact of Cost Disclosure on Firms

The operational impact of the cost disclosure requirements does to some extent depend upon the size of the organisation and the complexity of their revenue structure. A small boutique that does ten trades per day on a simple revenue model will be able to cope relatively easily. For the bigger firms, that make money in so many different ways, cost disclosure will be far more problematic. For example, a discretionary service will charge their client a fee for that activity. They will also levy a transaction-based charge, such as a flat fee for using a foreign exchange. There will then be market charges, such as stamp duty, and fund charges such as dilution levy (initial charge). There are also one-off fees, such as that for a certificated trade or an additional request for a contract note.

These charges are all being generated by different parts of the investment management platform; for example, the transaction-based charges may come in from the order management module or system. The real challenge of cost disclosure is retrieving this data from what could be up to five different sources and then validating it.

Firms are also struggling to gather the requisite product data. Many product providers are not supplying the full transaction cost data necessary at the required level. Some wealth managers are investing in products that are domiciled outside MiFID II, for example a US-registered Exchange Traded Fund. These product providers are not obliged to provide the necessary data, but the wealth firms are obliged to retrieve it if they are to fully disclose. Although with some products there may be an EU-based equivalent, these may be more expensive. It would be a sad irony if a firm had to transition a client onto a more expensive product in order to satisfy the cost disclosure requirements.

Of course, for some products, there is not yet ex-post data, and this will continue to be the case for any new products launched. Where the required data is unavailable, however, there is a lack of clear guidance on what information firms should use. ESMA suggests that the manufacturer should be contacted, but one must question the practicality of this advice. Should firms use ex-ante data where ex-post data is not available? Is it acceptable to use the Ongoing Charges Figure (Total Expense Ratio) if these do not include the transaction costs of buying or selling the underlying assets of the product?

Another key issue for wealth managers to address is that ESMA (European Securities and Markets Authority) and the FCA have declined to provide templates for cost disclosure, leaving it up to firms and trade bodies such as TISA (Tax Incentivised Savings Association) to create their own templates. This situation generates a number of important questions. There is a risk that those firms that have been most diligent in complying (ensuring that all costs are identified and disclosed while following an industry-recommended template) will be at a disadvantage. And will some firms take advantage of the situation and not fully disclose? What will the FCA’s enforcement policy be? How will they ensure that those not fully disclosing are penalised rather than those being most compliant? Unless there is a level playing field, the consumer is no better off.

It would appear that most firms are planning to disclose for a calendar year, so will produce their first report in January or February 2019. As a consequence, some firms seem to have put cost disclosure on the backburner while implementing their core MiFID II projects during 2017. However, even though costs are not yet being disclosed, the data still needs to be gathered. If, early in 2018, firms failed to capture costs that were not previously disclosed at the point of the transaction (such as implicit costs embedded within the price or FX markup), how will they ensure that this data is captured and disclosed?

What does all this mean for Investors?

Well, of course, most investors go to a particular wealth manager because of their performance record. Under the new cost disclosure regime, however, investors will be able to scrutinize the fee and cost breakdown of firms with comparable investment performance. Ex-ante cost disclosure means that prospective investors will be able to see the likely charges they will need to pay for any given amount of money invested in a particular product for the duration of a year. In theory, end investors will effectively have a ‘shop window’ environment.

Inevitably, there is a risk that investors will be encouraged to focus on costs and ignore other aspects of the service. Obviously, costs diminish returns, but as a new client the ex-ante cost is only part of the picture; good client management and consistent top quartile returns have to be paid for.

The fact that there is not a common template for the disclosure of costs will make it more difficult for end investors to compare. Additionally, there is currently very little ‘self-service’ ex-ante cost disclosure. Providing ‘self-service’ for a diversified discretionary portfolio may not fit the business model of a discretionary firm and may not suit the requirements of investors that desire such a service.

With the top line of fees and charges now effectively capped, if wealth managers are going to maintain their margins they will need to look at the bottom line. In other words, they will need to reduce their operating costs as a means of maintaining profitability. One major method of containing costs is increased automation; therefore, the need for improved processes and systems will come into even sharper focus as wealth managers face the fear of cost disclosure.