Implicit Costs: Are You Ready?
Of all the changes introduced under MIFID II on 3rd January 2018, it is perhaps the topic of costs and charges that has generated the most debate amongst asset managers. Specifically, implicit costs and charges. Yet it’s not just MIFID II that has been a hot topic for financial firms. Other regulatory regimes will also require greater transparency in how costs and charges are reported, such as:
- PRIIPs (Packaged Retail and Insurance-based Investment Products)
- Cost Transparency Initiative - affecting defined benefit pensions in the UK
- PS17/20 - affecting defined contribution workplace pensions in the UK
- Local Government Pension Scheme code of transparency
- RG97 - affecting Australian pension schemes
- Dutch pension fund disclosure regulation
So why is there so much discussion about implicit costs?
The objective of tighter asset management regulation is certainly laudable: to provide transparency into the trading costs of a fund, of which implicit costs are part, so that investors can make an informed choice. From an investor’s perspective, who wouldn’t want that?
Let’s step into the investor’s shoes and examine how well they might be served by the different methodologies for calculating implicit costs.
Implicit costs – done 3 ways
As an investor, let’s assume I want to invest in a fund that yields a high income. Having shortlisted three unitised funds that meet this objective, each having similar performance targets and risk profiles, the next step is to compare the costs.
The explicit costs across the funds do not differ much. The implicit costs may appear to be highly comparable too. The question this raises is – how accurate are the projected implicit costs? The implicit costs are not “charges” levelled against the investor, but are costs to the fund which impact performance. If a fund’s ex ante implicit cost projections are based on previous actual costs and accurately measured, then any ex-ante implicit costs indication can be trusted to at least be in line with historic costs. But if they are largely estimated and not based on actual implicit costs (because the asset manager does not have the capability to accurately calculate them), then there is a fair chance that they will not bear any resemblance to future actual implicit costs, Herein lies the problem.
As illustrated in Table 1, let’s assume that the implicit costs for the three funds in our scenario are calculated by using different methodologies, all of which, until recently, were methods acceptable to regulators. What does this mean in terms of true cost comparison?
Table 1: Implicit costs methodologies
On the surface, all three funds might appear to be relatively equal in terms of costs. But are the implicit costs calculated by using these different methodologies truly comparable? More importantly, do they reflect the future implicit costs of the fund?
A level playing field?
In our investment scenario, whilst the implicit costs of Fund 1 and Fund 2 are calculated by using a different methodology, both methods project realistic costs based on actual previous costs; these are adjusted for peaks and troughs, exceptional trading scenarios, and other justifiable exclusions. Over time, the actual implicit costs will adjust up and down in-line with the actual trading costs.
A closer look at Fund 3 reveals that it doesn’t bear any relation to the actual implicit trading costs incurred by the fund. The costs projected for Fund 3 are an estimate of what the implicit trading costs might be, based on the value of trades made; these costs are based on a standard assumption around trading costs (a proxy value). It is likely that the actual implicit costs incurred may not relate that closely to the costs quoted when the investor first made their decision to invest in the fund.
What this means for the investor is that there is no level playing field. The implicit costs projected for Funds 1 and Fund 2 are realistic and meaningful implicit cost indications, without necessarily being comparable. However, the implicit costs projected for Fund 3 can be very misleading.
Given our investment scenario, one year on, the investor may want to review the actual implicit costs incurred by their chosen investment. In the case of Fund 3, the investor may find that the costs incurred differ significantly from what was originally indicated. It may be that the implicit costs might differ for any of the funds in our investment scenario, however, for Fund 1 and Fund 2, the implicit costs are based on a robust methodology, whereas for Fund 3, this is not the case.
Why are firms slow to adopt regulatory change relating to costs?
There has been much speculation within the asset management industry over the methodologies prescribed by regulators for calculating implicit costs; knowing which method to pursue has been somewhat reminiscent of predicting which new emerging technology to adopt. With margins on asset management firms already squeezed, no one wants to build a solution based on what might be the predicted preferred method only to find it must be abandoned due to additional clarification around requirements.
Given our investment scenario, there is no doubt that the asset management firms behind Fund 1 and Fund 2 will have spent significant time, effort, and expense in establishing a robust methodology, processes and systems that can withstand scrutiny by regulators.
By contrast, the asset management firm running Fund 3 is likely to have cause for concern.
What is expected of firms in 2019 in respect of implicit costs?
One key development is that the data to support implicit costs is now becoming easier to come by. The availability of data for a wider range of asset classes is a key enabler, and it’s now easier than ever before for firms to adopt the arrival price method, or other robust methodology.
The Price Provision market leaders have taken much of the pain away for asset management firms to provide transparent cost data for their funds across the majority of asset classes. That is not to say that the arrival price method is available across every single asset class yet, but for the major asset classes, it is very much available.
There is now an expectation by regulators that firms will have made significant efforts to establish robust implicit costs processes and to have already moved away from unrepresentative proxy numbers. Any firm that continues to rely on what was introduced as a temporary method must surely now be moving towards an acceptable cost calculation method. It is likely that regulators will favour the arrival price method - the more commonly adopted method by larger asset management firms.
The arrival price method was the FCAs chosen method. Despite the noise made within the asset management industry challenging this approach, what’s clear is that the FCA has not changed its mind. As much as firms may want to wait in case they do, this will no longer wash.
While further clarification may be forthcoming, at this stage it’s unlikely that any sweeping change would be introduced, and so tweaking rather than wholesale re-engineering is likely to be the order of the day.
Is your firm ready?
Regulators will for sure come calling in 2019, and if your firm is on their list, it needs to be able to demonstrate that it has a robust implicit costs solution in place or can demonstrate that it’s has firm plans in place and is proceeding to implement such a robust solution.
If your firm has funds that fall into our Fund 3 scenario, the time to act is now to ensure your firm has a robust implicit costs process.
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