MiFID – Bad news for the distribution of investment funds

17 Nov 2017

Banks and other institutions often perform the role of distributors of investment products. Nobody inside the business is in doubt how it works: Roughly half of the income generated by a fund is kept by the provider, and half is kept by the distributor as the price for granting access to “their” customers.

This payment to the distributors has many names: distribution fee, retrocession or even “kick-back” are but a few. Let us play nice and call it retrocession.

Business insiders are well aware that the higher the retrocession, the bigger incentive for the distributors to push a fund to the investors.

This is about to change dramatically. From 3 January 2018 retrocessions are not any longer allowed. Yet, some payments from fund providers to distributors are allowed if the distributors provide a real service.

MiFID 2 takes aim at the retrocessions

MiFID 2 is zooming in on two major problems in the classical distribution model. The first is that investors interests are taking a back seat to the distribution efforts. The other is that the retrocession received by a distributor can be entirely divorced from the actual effort to sell the fund.

In the brave new world of MiFID 2, a fund cannot any longer be sold to a fund without some preparations. MiFID 2 operates with three ways a financial product can end up  in a customer’s portfolio. These are through an advisory process, as the result of a discretionary management agreement or by the customer buying from a fund platform without receiving advice at all.

From next year on, customers will have to pay for the investment advice they receive. It is specifically excluded to let an advisor receive a payment in order to provide “free” advice to the client.

Payments from a fund provider is only possible if the advisor clearly explains to the clients that the advice is not impartial. And in that case, advisor may only receive a payment covering the actual cost.

The advisor is requested to evaluate whether a given financial product is suitable for the client, given the customers risk profile. Oh, and that risk profile must be completed before any advice can be given. Advice must be in written form and countersigned before any transaction can take place.

Alternatively, the customer may opt for a discretionary management agreement. In that case it is the portfolio manager who will be responsible for matching products with the customer. And to explain how this is done.

In the case of a customer purchasing funds from an online platform, the platform must create a risk profile of the customer and block the customer’s access to funds that are not appropriate for the risk profile.

In all three cases, the advisor, be it a representative of the fund provider or not, has a strongly increased responsibility for matching customers and products, and to document how this is done.

This will effectively end the “product pushing” by the fund providers. We are likely to see considerable resistance from distributors to this change. It is likely they will be forced to toe the line by the FSA.

The EU has outlawed “most” of the retrocessions. Sweden, the Netherlands and the UK have outlawed retrocessions entirely. EU has maintained the possibility that fund providers grease the distributors just a little bit – under some rather strict conditions.

The most important is that the payments cannot be related to the size of the holdings. A distributor cannot any longer receive a payment calculated as a percentage of the fund products pushed out to the customers. The distributors can only be paid if they provide a “quality enhancing service” and then they can only be paid in relation to the actual services provided. What a Quality Enhancing Service consists of is as of yet not yet entirely clear.

Current distribution model will disappear

There is no doubt about the consequences. The distribution model as we know it will disappear. In the UK the adjustment has been swift and profound about 2/3 of the “independent investment advisors” that lived off the retrocessions are estimated to go out of business. Third-party distributors who did nothing except for creating a platform for sales of funds will have to improve their offering significantly. Investment advisors inside banks will have to declare their conflicts of interest.

But most likely we will see that banks focus on putting a maximum of their “in-house” funds into the customers’ portfolios and shutting down funds offered by other providers. If this happens it will be a major failure on the part of the EU: An Initiative aimed at giving the customers better and cheaper access to investment products, it may lead to a reduced product range offered to clients.

While the EU has not yet fully taken the step and abolished retrocession altogether, this author is not in doubt: In five years or so, a MiFID 3 package will do the job. EU will inexorably move towards a US infrastructure, where funds providers are entirely separated from the distributors and no retrocessions will be allowed. Investment advisors will have to live off what clients are willing to pay for the advice.

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