The Investment Association has called upon the Financial Conduct Authority to immediately suspend and replace the “profoundly flawed” Packaged Retail and Insurance-based Investment products (Priips) methodology for calculating implicit transaction costs.
Although the UK trade body said it is “wholly supportive” of the principles behind Priips, to provide investors with greater transparency and comparability across funds, it said this was being compromised by new performance scenarios and cost calculations that are “potentially misleading”.
“Urgent action is now needed by the FCA to address the flawed methodologies of Priips which are having harmful consequences for savers and investors across the UK retail and DC pensions markets,” said Chris Cummings chief executive of the IA (pictured).
“The FCA rightly called for evidence of investor detriment caused by the new rules. It has been delivered. The case is now proven and it’s time for action.”
Flawed implicit costs
The IA said the current way in which implicit costs are calculated has distorted costs and produced negative charges in some cases.
While explicit costs like brokerage and tax are fairly straightforward and easy to report, implicit costs, the loss of value that occurs when a stock or security is bought and sold, are trickier to pin down because they are so sensitive to market movements.
Instead of capturing the cost at the relevant time of the trading process, the bid/offer spread, Priips relies on a “slippage” method that measures implicit costs based on the difference between the security at the arrival time, the moment when a firm goes to market to place a trade, and when the trade is actually processed.
By employing this method, “the goal appears to be to create consistency, which we would support as a general principle in regulation,” the IA said. “However, for many strategies, asset classes and market sectors, arrival price has no connection to actual trading process or actual cost.”
Negative costs
The IA said as a result of the flawed methodology some funds were reporting negative and zero transaction costs. This in turn has reflected a wider distortion in all results, it said.
The FCA noted in its initial findings published in July that a “small number” of investment companies and funds are reporting negative transaction costs under Priips and Mifid II. It found that around 5% of funds are reporting zero transaction costs.
Seven of the most popular funds in 2016, including Nick Train’s Lindsell Train UK Equity fund and the Francis Brooke and Hugo Ure run Trojan Income fund, reported having zero transaction costs weeks after Mifid II regulation came into effect this year.
Other issues
The IA also highlighted the use of performance scenarios as a key area for concern.
Under Priips rules key information documents (Kids) for individual investments must illustrate the potential return to shareholders under various market conditions or ‘scenarios’ instead of relying on past performance data as it had done previously.
The new requirements have drawn fierce criticism from many in the industry, including heavyweight managers including Scottish Mortgage Trust manager James Anderson who said he was “extremely disturbed” by the changes and fearful they could lead to investors receiving poor information at the point of sale.
While the IA said the problem of the transaction cost disclosure lies in the calculation methodology, it stressed the issue with performance reporting is due to the approach itself.
“This is a more fundamental problem and not a question of whether there is a methodology that would be more meaningful for the scenarios themselves,” it said.
Proposals
Moving forward the IA has recommended three steps it would like the FCA to consider:
- An open and collaborative approach by EU and UK regulators to working with the industry and other stakeholders to develop the best solutions for investors. This would see a spread-based measure established as the starting point for implicit cost disclosure, and the inclusion of past performance within the Priip Kid.
- Immediate unilateral action by the FCA to suspend the use of slippage and substitute a half spread measure for Mifid and DC workplace pensions.
- Extension of the Priips Article 32 exemption for Ucits and non-Ucits retail funds at least until the Kid regime is amended to address the issues raised and thereby ensure that retail investors continue to have access to the most useful information.
