Product governance considerations under MiFID II
Investment managers running UCITS funds or Alternative Investment Funds (AIFs) will not fall directly under MiFID II or have any legal obligation to comply with regulation or require a MiFID license. However, from a product governance perspective, they will be impacted indirectly. This is because their fund distribution partners, such as MiFID licensed bank platforms, will be required to define the investor target market for each product.
"Consequently, if Asset Managers want to stay in business it becomes essential for them to define the target market for all their funds at the share class level and communicate this to their distribution network," explains Mario Mantrisi (pictured), CEO of InReg, a sister company of KNEIP, one of the fund industry's foremost legal and regulatory report providers.
AIFMs or UCITS managers will be required to provide a sufficient level of product transparency in order for fund distributors to make a clear judgment on whether the fund is suitable to the clients that the fund sponsor wishes to sell it to.
Defining the target market
ESMA has come up with six categories to define the target market, however these need to be described at a more granular level on the manufacturer side. These categories will include the ability for the investor to bear losses and as Mantrisi explains: "We will probably end up classifying products in distinct categories, varying from cases where the investor can bear minimal losses of capital at the one extreme, to where the investor can bear losses beyond the investment amount at the other extreme."
So far, the template for defining the target market has yet to be finalised by ESMA. In the opinion of Raymond Groen in't Woud, Product Director, the AIFM can say that they have no view on this and that it is down to the distributor to redefine its own target market model.
He says that the main challenge to this is that individual EU countries will have their own definition of target market on the distributor side. "Consequently, products that are distributed cross-border need to be prepared to cope with slightly different definitions, and the product target market definition will need to be adapted for different markets."
"I don't think this will be the most complex piece under MiFID II nor, from what I am seeing in terms of the measures being taken in countries like Germany, will it be too problematic. However, the target market definition should have been finalised some time ago, to allow firms to make the necessary plans," explains Gary Janaway, COO of KNEIP.
Just as the AIFM will have significant responsibilities in providing distributors with sufficient transparency and detail to meet the target market requirement, equally the distributor will have responsibility to ensure that the fund sponsor is made aware of what is referred to as a `Negative Target Market'.
"This is where a specific investor is deemed not to be suitable to invest in the fund. From a distribution chain perspective, there will be an obligation on MiFID II-regulated entities to relay that information back to the Management Company," says Groen in't Woud.
Mantrisi points out that whilst the understanding is that distributors will be required to report back on negative target market, where the product does not match the target market definition, not all distributors will necessarily be able to do this.
"Consequently, Asset Managers should define how much responsibility they are prepared to take when it comes to distribution oversight duties and decide what their policy shall be in cases of missing and incomplete reporting," advises Mantrisi.
Under MiFID I, fund sponsors could simply delegate the transparency requirements to the distributor. Under MiFID II, that responsibility moves up the chain from the distributor to the fund sponsor. If they aren't receiving negative target market data, or some sort of confirmation from their distribution arm, the fund sponsor could be perceived as not being active enough, in terms of product compliance, and run the risk of being liable.
The Asset Manager must now be able to receive information about the entire fund distribution chain and gain a transparent view through platforms and nominee structures to ensure that the product governance rules are properly applied.
"Through obtaining a full transparent look through on investor positions and transactions, the Asset Manager can validate the product governance rules set," asserts Groen in't Woud.
Level of transparency facing fund sponsors
In brief, Article 25 of MiFID classifies UCITS (except for structured and alternative UCITS) as non-complex and further states that shares admitted on a trading market should be classified as non-complex, except for shares in non-UCITS collective investment undertakings.
Therefore, all AIFs, no matter how straightforward their trading strategy, will be treated as complex, which will have implications in terms of how and to whom that fund can be sold.
"In principal, if it is classified as complex you are only allowed to sell it in execution only models but you need to make a suitability test before you sell the product.
"Then you need to define what type of clients you are selling to; are they institutional investors or retail investors? Next, you need to define the risk appetite of investors as part of the target market exercise.
"Also, there is a disclosure of the costs. This needs to include ex-ante costs, which are estimations on the past, and ex-post costs on a yearly basis, which detail the actual costs incurred by the fund," outlines Mantrisi.
A new family of fees
UCITS funds, which have for some years been engaged in disclosing fund costs to investors in the Key Investor Information Document (KIID), including entry and exit charges, ongoing charges and performance fees, will now face even further cost transparency disclosure. This will largely be in relation to transaction costs.
This break down of transaction costs is a whole new area for the funds industry and will present a particular challenge, especially when it comes to implicit fees on instruments that are not traded like equities or bonds.
"A methodology for determining a mid-market rival price will be needed on which to base the implicit fees. This is new for UCITS and AIFs," says Mantrisi.
"Up front costs at the pre-sale stage (ex-ante costs) will need to be provided to distribution partners on a quarterly basis on every fund, down to the share class level. Then, on an actual (ex-post) basis, transaction costs and the total cost of the product will need to be disclosed to investors, on an annual basis, to show how much the fund product actually cost that year," explains Janaway.
Whichever way one looks at MiFID II, it is clear that AIFMs and UCITS managers will need to demonstrate clear and evidential product governance to meet the distribution requirements of the regulation.
"It's ultimately about having a responsible relationship and making sure the right clients are in the right products. If it doesn't work well, and information is not being shared adequately when a negative target market is identified, it will negatively impact both the fund manager and distributor," concludes Janaway.