The ratings agency sets out a range of ways in which the sweeping new EU rules change the stakes for investment managers and, ultimately, their clients.

(An earlier version of this item appeared on Compliance Matters, a sister news service to this one.)

The European Union’s second Markets in Financial Instruments Directive is now in effect and is changing the ways in which asset management products are designed and sold.

According to Moody's, the credit rating agency, the directive is having a “credit negative” effect on the EU's asset management industry and its ramifications could spread beyond Europe. 

Marina Cremonese, a Moody's vice president and senior analyst, wrote the report. In it, she argued that exchange traded funds will gain market share because of the new regime, attracting both retail and institutional investors. MiFID II increases cost transparency and bans commissions for independent financial advisors. 

By revealing the real costs of actively managed funds, cost-conscious high net worth and retail investors will turn to cheaper passive funds that track indices, such as ETFs. In Europe, the growth of ETFs has so far lagged behind that in the US market (although growth has been rapid). Most US growth comes from retail investors managing their retirement savings. Europeans do not manage their own retirement savings to the same extent, and as a result have less control over how assets are invested, but this is changing with the growth of defined contribution pension plans and pension freedom in the UK. In Europe, banks dominate retail distribution and have had less incentive to sell ETFs that don’t attract large commissions. MiFID II's increase in information for investors will change this.

ETFs were excluded from the original MiFID rules in 2004, which made it hard for analysts to assess ETF liquidity issues in Europe. The second instalment now requires every ETF trade to be reported. Institutional investors, according to Cremonese, now can see the full (rather than only partial) ETF trading volumes and liquidity for the first time.

Cremonese also writes that “cost transparency” and better comparability between products will make fees more competitive. MiFID II requires asset managers to give clients detailed information about costs and charges paid to provide investment services. This includes one-off costs (such as structuring fees and front-loaded management fees), continuing charges (such as management fees, service costs), costs related to transactions (such as entry or exit costs), incidental costs and performance costs.

All these costs and charges must be aggregated and the total sum provided to the client to show how it affects investment performance. For the first time, investors can now compare product costs easily. These requirements apply to all retail funds, private clients and institutional funds operating in the European Union (EU). MiFID II also applies to discretionary fund managers and indirectly to UCITS (Undertakings for Collective Investment in Transferable Securities) management companies and Alternative Investment Fund Managers (AIFMs) where they delegate funds or distribute them through MiFID II-regulated entities. 

Some cost disclosure for funds already appears in key information documents attached to mutual funds, but MiFID II requires more detailed reporting and full cost aggregation. New MiFID rules also introduce a product governance regime applied to the product development and sales process. 

Asset managers must create product governance policies and procedures to design investment products to meet needs of identified target markets and distribute them to the target market. A fuller disclosure of product costs and risks will allow investors - and competitors - to compare products far more easily and ultimately drive asset management fees downwards.
 

Bigger than RDR
The author of the Moody’s report expects MiFID II to have a bigger effect on management fees than the Retail Distribution Review (taking effect in 2013) had in the UK. During the next two years after 2013, continuing charges for active funds fell slightly, while for more transparent passive funds, charges fell between 15 and 20 basis points. MiFID II will affect active management as well as institutional assets, and European asset managers' effective fee rates could fall by 10 per cent to 15 per cent as a result, depending on their asset allocation and on their responses to various pressures. 

Asset managers, Cremonese says, will probably respond by narrowing the range of products they sell, and will likely be forced to consider closing funds that have been consistent underperformers. Such measures, along with cost saving initiatives, innovative investment solutions and possibly M&A, will offset some of MiFID II's negative effects, limiting their credit impact. 

Funds are already falling by the wayside because of investors' disappointment with active management performance. The European fund industry has lost about 3,000 funds over the last six years. The perception of underperformance was reinforced following a European Securities and Markets Authority (ESMA) survey in February 2016, which concluded that between 5 per cent and 15 per cent of the 2,600 European equity funds it analysed could be more accurately classified as index-tracking funds. In era of MiFID II, according to Cremonese, HNW investors will no longer tolerate such benchmark-huggers.

Moody's expects MiFID II to change asset managers from product manufacturers to something it calls “solution providers”. The pitfalls that asset managers face when trying to beat a benchmark were further exposed in an asset management study published by the UK's Financial Conduct Authority in June last year. 

The FCA found that, on average, funds do not outperform their benchmarks once the fee has been included. In the face of scepticism from investors about the value of active management, asset managers are turning towards results-oriented ways of doing things and Moody's expects MiFID II to accentuate this trend. The “investment solutions” it mentions, often combining multiple asset classes, are a means for asset managers to move away from traditional active management (involving the targeting of a benchmark) and instead to follow strategies whose objectives are to attain the goals of investors, such as a retirement income, school fees or a targeted total return. In this way, asset managers can customise products to help HNW investors achieve financial goals for specific life events.

MiFID II's new product governance and product suitability rules will push assets managers further down this path. Evolution away from traditional benchmark-driven funds towards outcome-oriented investment strategies will accelerate.

Asset managers will suffer from squeezed margins and, think Cremonese, the smaller among them will then sell themselves to the larger. MiFID II is changing the process of trading, execution, product conception, governance and distribution. It also imposes fairly onerous reporting requirements on them. Beyond the one-off upfront implementation costs, asset managers will have to keep on paying to comply. 

Optimas, a European consulting and research firm that specialises in asset management, risk management and regulation, estimates that the 15 largest asset managers spent an average of €10.3 million ($12.6 million) to obey MiFID II. It estimates a maintenance cost of €4.5 million ($5.52 million) a year for the next five years.

Investment research must now be paid for. Asset managers must now make explicit payments for the investment research they receive from banks and broker-dealers, which was previously bundled in with trading costs. Many managers have said that they are going to absorb these research costs instead of passing them on to their HNW clients. 

Altogether, between compliance, disclosure, budgeting, audit requirements and research costs, Moody's guesses that asset managers' costs could increase between 0.5 per cent and 5 per cent. Assets managers that will absorb research costs (especially those with large product ranges that concentrate strongly on equity, where reliance on external research is higher) will be the most affected. We expect this will result in asset managers being more selective in the investment research for which they pay.

For some, it may mean creating or expanding internal research capabilities. Deutsche Bank, for example, launched a research division as part of its existing asset management division last year. This will probably put pressure on smaller managers who may find it harder to absorb the cost of research themselves. 

In October last year, the ICMA’s Asset Management and Investors Council (AMIC) surveyed its members to discover firms' current intentions and their progress regarding MiFID II research unbundling, with a specific focus on research dedicated to fixed income, currencies and commodities. Respondents said that they expected their research expenditures to increase next year and the number of providers to decline.