In search of value for money
Value for money testing as part of investor protection has become a central focus for regulators in recent years.
In the EU, the very comprehensive Retail Investment Strategy (RIS) proposal was put forward in May 2023. This proposal had been several years in the making, layering on top of previous regulations such as MiFID II, PRIIPs and AIFMD.
Overview of the EU Retail Investment Strategy (RIS)
Some interesting themes in the initial outline include ensuring that financial advice is aligned with retail investors’ best interests, that financial advisors examine retail investors’ financial situation more carefully and that financial advice better meets the needs and objectives of retail investors. There is also a pledge to improve both financial advisors’ and retail investors’ knowledge of financial markets.
These basic and self-evident concepts have appeared many times in previous regulations. They were addressed by PRIIPs and MiFID II, which have been in force for nearly seven years.
Further goals in the RIS proposal include modernising disclosure rules, adapting them to the digital age and investors’ sustainability preferences, and requiring that marketing be fair, clear and not misleading, including that conducted via digital channels and finfluencers.
These points address the changing technological and social landscape that the investment world now finds itself in. The catchy term “fair, clear and not misleading” was first used by the FCA over ten years ago and has been wheeled out again. This demonstrates that making real progress can be slow.
Two other points introduce the value for money concept, emphasising t need to develop benchmarks against which the value of financial products should be assessed. The aim is for all investment products to deliver real value for money to retail investors ensuring that demonstrably fail this test are never brought to market.
Value for money, as a direct measurable outcome, refines the way regulators approach protecting investors. It represents a natural development made possible by increased sophistication across the industry, more available data and growing acceptance of benchmarks and comparison techniques.
In June 2024, the EU Council provided further details of Retail Investment Strategy and much of this was devoted to what it calls a new concept of ‘Value for money’ to ensure that investment products are offered to retail clients only if they offer good value for money.
The new rules will place an onus on manufacturers and distributors to assess whether costs and charges related to a product are justified and proportionate. To help achieve this, the EU Council is calling on ESMA and EIOPA to develop benchmarks against which individual products could be measured to assess value for money, including comparisons against a peer group of other investments.
A comparative look at the UK and EU
In the UK, the wide-ranging Consumer Duty directive has placed price and value as one of its main outcomes in measuring investments sold into the retail market. Consumer Duty came into force in July 2023 and is still undergoing a lengthy period of adoption and assimilation by both firms and the regulator. Firms are now gaining practical experience in how to best implement all its aspects, while the FCA continues to do research, make investigations and provide further comment and guidance. The EU Retail Investment Strategy is taking a similar approach. Earlier precedents in structured products include the 2015 FCA Thematic Review and the trade body UK Structured Products Association reacted with its own value for money test in the same year, anticipating the current approach of regulators.
Value for money is not an easy concept to put into consistent practice. In order to try and tackle it, the EU is reverting to its usual instincts of extremely detailed and prescriptive rules and methodologies.
Measuring value for money should depend on the type of investment, the level of risk, and what alternative similar choices are available. It is also very difficult to isolate the notion of value for money from actual returns, which immediately raises questions of timing and asset allocation. This is particularly true for investments such as structured products where the benefit to investors can only fully be measured at maturity. The EU is now proposing the use of theoretical benchmarks and considering competing investments in the same “peer” group. This approach may lead to confusion, inconsistencies or attempts by investment groups to manipulate the most favourable evaluation methods.
The European Structured Product Association (EUSIPA) published its members’ positions on proposals for Value for money testing.
As an EU-wide body representing Structured Products firms across the region, it has considerable experience and resources to comment on any new proposals. The nature and diversity of structured products mean that having a fair framework right is important and likely to be more challenging than for funds for example.
In its recent paper, it outlined five key points it wanted to address and potentially see changes in the final rules.
Its first point is that value for money should require the use of asset-specific methodologies with no prescriptive or arbitrary cost limits should be applied to all investments.
There is some logic in this position since value for money should be about fees being proportionate to what is being delivered, rather than adhering to any “absolute” scale. EUSIPA has taken a strong position here, but convincing the EU may be problematic and it is also likely to be met with resistance from funds groups. The argument that EUSIPA has put forward is similar to the active versus passive fund debate that has existed for decades. The passive fund sector argues that low-cost funds tend to deliver better value because on average active funds have not outperformed passives when higher fees are taken into account. Successful active fund managers would argue that their performance does not justify any higher fees.
A further complication for structured products is that, while it is possible to identify distributor fee levels, the embedded costs due to the profit the bank is taking cannot be precisely identified. Relying on performance alone as a determination runs into challenges related to market timing and appropriate benchmarks.
Key recommendations on value for money testing
The second point made by EUSIPA is to allow for “synthetic benchmarking” by using forward-looking simulations to compare structured product returns to the risk-free rate (for capital components) and equity or other asset class risk premium. This is very similar to the approach successfully taken by the UK Structured Products Association for the last ten years.
The EU proposals emphasise the concept of “peer” analysis, which involves comparing an investment to similar ones in the marketplace. This is very similar to the simple idea of placing a fund performance in its sector quartile. EUSIPA chose to use the term “peer conscious” to mean that all its members would unite behind a common testing methodology which is not quite the same thing.
EUSIPA’s third point recommends that leverage products be assessed solely by costs and not by any performance measurement. This is a reasonable point to make but further highlights the attendant difficulties in any methodology and when exceptions should apply. Other investment types may seek other carve-outs (e.g. leveraged ETFs, certain insurance products, short-dated deposits etc), but juggling them all will be difficult.
The final two points considered by EUSIPA are more philosophical. Firstly, it requests that “best interest” as defined by MiFID II is not amended or extended by this legislation. Secondly, it asks that “not to link suitability with the absence of unnecessary features”. One of the proposals put forward by the EU is trying to do precisely this: “Investment firms cannot consider a product to be suitable where it contains features which are not necessary to the achievement of the client's investment objectives and that give rise to higher costs.”
EUSIPA has put together five noteworthy points in response to the detailed value for money testing proposals from the EU. This journey will have a long way to go until implementation and adoption.
Everyone would agree that value for money testing is a worthy ideal, but the recent experience of the PRIIPs regime where a very prescriptive and ambitious approach ran into major difficulties must be remembered. Principles-based approach rather than heavily rules-based one, might be the best way forward and mistakes made at the outset could take years to unravel.
Tags: RegulationImage courtesy of: Christian Lue / unsplash.com
