Download report on fees and charges paid by investors in collectively

REPORT ON FEES AND CHARGES
PAID BY INVESTORS IN
COLLECTIVELY MANAGED
SCHEMES IN FRANCE
EXECUTIVE SUMMARY
Presented on 9 October 2002
Introduction
Investment management has developed at an exceptional pace throughout the OECD area. This
is especially true in France, which has €590 billion under discretionary management and
€820 billion invested in collective schemes. Consequently, managed investment is now a key
financial activity in France and is gradually playing a greater role in boosting domestic saving.
Growth has been particularly brisk in the sphere of collective management, handled through
undertakings for collective investment in transferable securities (UCITS) organised as openended investment companies (sociétés d’investissement à capital variable, SICAVs) and unincorporated
investment trusts/common funds (fonds communs de placement, FCPs).
The success of the investment management industry hinges on the good relationship between
investors and industry practitioners, particularly in terms of fees and charges. These expenses
must be evenly balanced so that they do not take too much out of profits but are sufficient to pay
for a high level of service. In addition, they must be transparent and fully understandable to
investors, in view of the relationship of trust with investment professionals. Last, they must
foster healthy competition among practitioners.
With this in mind, the Commission des Opérations de Bourse (COB) set up a working group in
September 2001 to investigate UCITS fees and charges. The group was chaired by Commissioner
Philippe Adhémar. The COB took note of growing concern among regulators in leading
countries about investment management fees. Those concerns arise from two convictions:
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investors must give the same degree of consideration to fees and charges as they do to
management policies and performance when deciding whether to invest;
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full disclosure of fees and charges does not work against the interests of investment
professionals; on the contrary, it is vital to the success of their business in the long term.
Compared with the rest of Europe, the French investment management industry is already well
placed as regards rules on best practice, investor protection and disclosure. Starting from these
achievements, the working group sought to keep France in line with the highest international
standards by pursuing three goals:
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provide investors with balanced and clear information;
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ensure sound, transparent practices that bolster the relationship of trust between practitioners
and investors;
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promote a mature, efficient market in investment management by fostering healthy rivalry
between industry practitioners and competitiveness in terms of prices and service quality.
The group framed a set of proposals which, by unanimous agreement, would provide investors
with better information, help them select their investments and protect them more effectively.
However, to avoid competitive distortions, some group members advocated that proposals
regarding information provided in a scheme's prospectus on past performances and reference
indicators should be conditional on adoption at European level. The members stressed that
regulatory harmonisation was a prerequisite for building a European market in investment
management.
1 ) The current situation
Essentially, investors are liable to pay three types of expense:
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entry and exit fees, paid directly by the investor when UCITS shares or units are bought and
sold. Basically, these fees cover product distribution and the costs to the scheme of buying
and selling;
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management fees paid by the UCITS and charged against its net asset value; they cover all the
scheme's operating costs (administration, accounting, depository and custody services) as well
as general portfolio management. In many cases, management fees cover distribution costs by
means of rebates granted by the management company to the marketer;
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transaction costs on securities in the portfolio: these are never factored into the scheme's
management and operating expenses but they can nevertheless have significant impact on
performance.
France has long organised investor-related information via the notice, or abridged prospectus. This
simple, concise document comprises between one and three pages and sets forth the key
characteristics of the fund in a clearly understandable manner in order to help potential investors
make informed decisions.
Fees and charges are presented clearly and in summary form. The scheme's total operating and
management expenses are described in the form of a maximum annual rate.
International comparisons
International comparisons are complicated by the fact that different regulatory systems do not
have a standardised presentation of fees and charges. This lack of standardisation is particular
acute in Europe because, under the terms of a 1985 directive, a UCITS that is registered in a
member state and complies with the directive can be marketed throughout the European Union.
Thus there is a risk of competitive distortions within the single European market. This must be
tackled by efforts to bring regulatory systems (and taxation regimes) into line with each other.
Those efforts were given fresh impetus by two directives published in February 2002 to amend
the 1985 directive, notably by establishing at European level a simplified UCITS prospectus
similar to the notice issued by French funds.
France emerges favourably from European comparisons in terms of both investor information –
notably the presentation of overall fees as a single maximum rate – and the average level of fees
and charges.
Statistical data on income breakdown in the French investment management industry
These data demonstrate the dual significance of the system of rebates:
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for distributors, and especially banks, which account for some two-thirds of all rebates.
Through a system of front load and shared management fees, distributors attract most of the
gross income (estimated at 74 percent on the basis of a sample) generated by collective asset
management for retail investors;.
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for management companies, some of which derive indirect income from UCITS transactions
(fee sharing agreements on transactions costs) and from the acquisition of schemes by funds
of funds or under mandates (fee sharing agreements on the management fees of the
underlying collective investment schemes). These revenues are trending upwards and now
account for 7.7 percent of management companies' operating income.
2 ) Improve investor information
The group concluded that regulators should not be responsible for controlling the level of fees
and charges in the collective management industry. That said, based on international data, these
expenses do not seem disproportionate in France by comparison with other European countries.
By contrast, further work could be done to improve investor information by building on the
existing positive foundation, namely the clear presentation of total fees and charges in the notice
given to investors prior to subscription.
A new yardstick comparable to the Total Expense Ratio: 'Total de Frais sur Encours’
(TFE)
At present, the optimal international standard for measuring investment costs is the Total
Expense Ratio (TER), which calculates a fund's aggregate expenses (excluding transaction costs)
as a proportion of assets under management, expressing the result as a single percentage. The
concept of "management fees" as they are currently presented in France, is already similar to the
TER.
The working group proposed adopting a ratio called "Total de Frais sur Encours" (literally: total
expenses over managed assets, or TFE). The new ratio would be presented, inclusive of tax, as a
percentage of assets under management in all investor-related documents. Moreover, in addition
to the theoretical maximum rate, the actual rate for the preceding financial year should be shown.
Improving the prospectus
According to the working group, the opportunity has arisen to review the notice – the longstanding achievement of the French investment management industry in terms of investor
information. The new European UCITS directive, which is to be incorporated into national law,
has adopted the principle of the notice, calling it "simplified prospectus". The directive introduces
a significant innovation: the presentation of historical performance.
The group made the following proposals:
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The prospectus should comprise two parts. Part A, provided for in the fund's statutes and
containing the information currently provided in the notice (investment objective, operating
methods, etc.), and part B, containing quantitative historical information.
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Part B should relate not only to historical performance but also to information that could
enlighten the investor about, inter alia, the real expense ratio (see above) and portfolio
turnover over the previous financial year.
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A reference market indicator (or benchmark) should be adopted and displayed up-front by
the management company to enable investors to assess the scheme's performances.
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A degree of standardisation is needed to facilitate historical performance comparisons.
Performance should be calculated over one and three years as well as over the recommended
investment period. It should be calculated net of total management fees only. Moreover,
throughout the recommended investment period, performance would be presented net of all
commissions and expenses, including front load and exit fees.
Although these proposals were unanimously endorsed by the group, some members advocated
that two of them – the use of a reference indicator and the calculation of past performance net of
purchase and redemption commissions – should be conditional on adoption at the European
level in order to avoid competitive distortions between different regulatory systems.
Clearer explanation of performance-based fees
The COB has permitted UCITS to charge this kind of fee for many years. The working group
called on the COB to update the framework for fees, in collaboration with industry practitioners.
Particular attention should be paid to the principle of shareholder equality, in order to prevent
excessive asymmetry of risk and reward between unitholders and the management company,
thereby ensuring consistency between a scheme's management and the method of remuneration.
Supplying documents to investors
The working group wants to clarify the ways in which regulatory documents are supplied to
investors, e.g. upon request, in connection with the subscription form, or via the COB website.
The aim is to ensure that investors actually receive the requisite information.
3 ) Stricter transparency requirements for transaction costs
Transactions generate three types of costs for a UCITS:
• intermediaries' fees (brokerage commissions). These are not necessarily explicit for financial
instruments traded on a net basis, e.g. fixed-income securities, derivatives;
• expenses (stamp duty, miscellaneous trading expenses);
• market impact, i.e. the difference between the order execution price and the best limit prices in
the order book
Fund managers have been forbidden from receiving rebates on brokerage fees since 1997.
Therefore, current regulations make it permissible for transaction costs (or trade commissions) to
include a "shared commission", split between the depositary and the management company.
Three remarks are relevant in this respect:
− Unlike other expenses, transaction costs are not included in the Total Expense Ratio (TER).
They do not have to be displayed, they are not capped, and they are taken directly out of the
fund's profits.
− Transaction costs can be significant relative to TER.
− Keeping transaction costs under control is one of the obligations of the fund manager and is
key to sound management, pursuant to the regulatory best execution principle.
Fuller disclosure of transaction costs
One of the main advantages of collective management is that the investor benefits from
transaction cost savings, attributable to the manager's professional skills and to economies of
scale. For this reason, it is necessary to compute those costs and then communicate them to
investors so they can gauge the manager's performance.
The working group wants fuller disclosure of transaction costs, to be achieved by:
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giving the following prior-year information in summary prospectuses and annual reports: the
fund's annualised turnover ratio, the ratio of identifiable trading costs (brokerage
commissions) to average net assets, and, at management company level, the percentage of
commissions and buy/sell flows dealt through tied brokers, analysed by asset class and
accompanied by explanations where necessary;
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providing more detailed information about the implementation of principles already laid
down by regulations and best practice requirements for execution. The group noted that the
French asset management association, AFG-ASFFI, has undertaken to prepare a ‘best
execution’ quality charter;
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describing in the annual report the process used to select intermediaries and the ways in
which the fund seeks best execution (with reference to the AFG-ASFFI charter, where
appropriate).
Improving the regulation of rebated trade commissions or "shared commissions"
Shared commissions are currently permitted under the COB regulation on the rules of conduct
for asset management services, which outlaws rebates on brokers' commissions. The method
used to apportion trade commissions among the practitioners involved must made public. This is
done through the yearly management report, in the case of discretionary clients, and through the
annual report for UCITS unitholders.
From the economic standpoint, the significance of shared commissions is generally limited: they
account for less than 5 percent of management companies' aggregate operating income, and most
companies receive nothing.
However, some management companies depend heavily on shared commissions. The following
arguments have been put forward in favour of this method of remuneration:
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It is needed to cover the substantial costs generated by internalised order systems put in place
to provide best execution.
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Because customers judge a management company according to its performance, excessive
costs charged as trade commissions would ultimately go against its interest. Moreover,
unjustified portfolio rotation by a management company would be liable to sanctions..
The working group concluded that rebating trade commissions to distributors, either partially or
in full, could compromise a fund manager's independence. It therefore proposed to immediately
ban direct or indirect rebates of trade commissions to marketers (referral agents, sponsors or
distributors).
The group also found that the practice of sharing commissions raised several sensitive issues:
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At present, management fees are intended to cover a management company's total costs,
including the cost of placing orders. However, comparisons based on the Total Expense
Ratio do not take account of rebates and can therefore be skewed.
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Allowing fund managers to charge a mark-up on transactions may encourage churning and
result in shortcomings, even though these would remain exceptional and contrary to conductof-business rules.
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The requirement to inform investors about the basis of apportionment of trade commissions
is inadequate in principle and poorly implemented in practice.
At the same time, the working group wanted to take into consideration the fact that several
management companies now depend heavily on rebated commissions. It therefore recommended
the following improvements:
- the summary prospectus must specify whether a shared commissions is received;
- the management report and part B of the summary prospectus must specify the real proceeds
(as a percentage of the fund's net assets) from commissions on transactions shared between the
management company and the depositary, as well as the basis of apportionment.
An ethical approach to soft commissions received from intermediaries
Soft commissions consist of services provided, or paid for, by an intermediary to a management
company in return for order execution business. "Softing" often takes the form of research
services and subscriptions to financial databases.
The UCITS code of good practice already states that (i) soft commissions must consist of
resources or services intended to improve the quality of investor services; (ii) they must have a
direct bearing on a fund manager's business and must not inflate brokerage commissions, which
must be in line with market conditions; and (iii) they must not be a determining factor in the
choice of intermediary.
A long-established practice in other markets, softing has developed in France since the rebating
of brokerage commissions was banned. Based on a sample of annual reports, 20 percent of
companies state that they benefit from soft commissions.
Good practices must be further encouraged by expanding the aforementioned code so as to
strengthen the best execution principle. This would also provide an opportunity to itemise the
goods and services that can be provided under a softing arrangement.
Investor information could be enhanced by giving the following information in the UCITS'
annual report, as some management companies already do:
− the rules that the company undertakes to follow in terms of soft commissions received from
intermediaries (the type of services accepted, details of how they are accepted and used, a
systematic assessment of their value, and procedures for dealing with conflicts of interest
when selecting intermediaries);
− the actual proportion of soft commissions in the management company's total operating
income, where this exceeds 1 percent.
4 ) Distribution costs
Marketing a UCITS consists not only in selling the scheme to investors but also in providing
them with advice and expertise over an extended period. Where the marketing function is
separate from management – as it usually is in the case with schemes sold to retail investors – it is
remunerated through subscription fees and rebates on management fees paid by the management
company to the distributor.
An analysis of the abovementioned sample of companies estimated that distribution accounts for
74 percent of the gross income of UCITS sold to private investors. More than one-half of this
sum consists of rebated management fees, and the remainder mainly of front load.
The working group addressed the issue of disclosure of distribution costs. Strong arguments exist
in favour of greater transparency : distribution costs account for a substantial proportion of total
expenses; the rebating system is non-transparent; and there is an increasing separation between
the distribution and production functions. One way to achieve fuller disclosure would be to
separate the cost of production stricto sensu from the cost of distribution when presenting total
fees and expenses. A similar distinction already exists for mutual funds in the USA.
At the same time, the working group noted that clients are interested first and foremost in what
they will have to pay rather than in a detailed cost analysis. As far as the client is concerned, those
costs cover both management and advice.
The debate on disclosure is related to the issue of different categories of unit or shares, which are
not authorised under French law. Such a system would make it possible to differentiate a UCITS'
distribution-related expenses by type of unitholder. In practice, the fact that European countries
authorise different unit categories means that France already accepts this system on its territory
because it allows the marketing of European UCITS that comply with the directive.
Moreover, it is necessary to establish a link between, on the one hand, proposed reforms to the
distribution of financial products and cold calling and the creation of a semi-regulated regime for
independent financial advisors in France, and on the other hand, the method of remuneration.
The group adopted two guidelines:
− allow management companies to choose whether to disclose distribution costs and whether
to identify them separately from operating costs in the summary prospectus;
− create different categories of units for UCITS organised under French law .
5 ) An appropriate framework for funds of funds
Funds of funds were launched in France during the 1980s. They gained strong momentum with
the emergence in 1996 of balanced funds and again in 1998-99 with the introduction of a specialpurpose legal framework. Funds of funds play a significant role in the French investment
management industry: UCITS with more than 50 percent of their assets invested in other
schemes make up nearly 17 percent of all French UCITS and account for 8.4 percent of assets
under management (24 percent and 17 percent, respectively, for UCITS with between 10 and
50 percent of their assets invested in other UCITS).
Because funds of funds are flexible, they are used for many purposes, ranging from simple
combinations of proprietary funds to full-scale multi-management.
Funds of funds are likely to experience fresh growth as a result of the new UCITS directive,
which recognises them under a slightly different form to that currently enshrined in French rules.
Considering the increasing importance of these vehicles, an appropriate framework is needed to
ensure they function in a sound and transparent manner.
Accumulated expenses
Funds of funds accumulate expenses in the form of management fees and
subscription/redemption commissions, incurred both directly and through the underlying funds.
French regulations seek to prevent cascades of funds by outlawing "funds of funds of funds".
They also require UCITS investing more than 50 percent of their assets in other schemes to
disclose the maximum expenses borne on the underlying UCITS.
The working group concluded that three improvements could be made:
− To provide greater clarity on total expenses, the summary prospectus must show not only the
fund of fund's direct expenses but also aggregate TER, including the indirect expenses borne
on account of the underlying UCITS.
− The annual report should detail the expenses actually borne for the underlying funds, both as
an amount and as a ratio of the UCITS' average net assets;
− The aggregate TER of the fund of funds and its underlying UCITS must be indicated when it
exceeds 10 percent of the fund of funds' assets (not 50 percent).
Methods of rebating expenses in funds of funds
The development of funds of funds in France – and probably in Europe – involved the practice
whereby the management companies of the underlying funds paid referral commissions ("finder's
fees") to the companies managing the fund of funds. However, this practice has been challenged
by several regulators, and Italy's CONSOB recently published a report on the subject. The main
objections are:
− The rebate mechanism is non-transparent for investors, who are rarely provided either with
information about the real remuneration of the fund of funds' management company or with
the breakdown of such rebates by underlying fund.
− It creates a conflict between the investor's interests and the immediate interest of the
management company, which may be inclined to choose underlying funds that generate the
highest rebates.
− This method of remuneration innately demonstrates how the service provided through a fund
of funds varies between fully fledged investment management, which is remunerated via a
management fee, and the simple distribution of a UCITS, which is logically remunerated by a
rebate on management fees.
For these reasons, a more satisfactory regulatory framework for funds of funds should be sought:
− For the short term, the working group considered it necessary to enhance the information
provided to investors about the rebating mechanism in funds of funds. The summary
prospectus should indicate whether such rebates exist and, if so, express them as a maximum
percentage of the fund of funds' assets (part A), and show the actual rate for the previous
financial year (part B).
− Any reduction in the negotiable portion of subscription/redemption commissions should
accrue to the fund of funds. Moreover, the EU directive provides that these commissions
should be banned in the case of funds managed by the same management company or a
related firm.
− Preparations should be made to amend the fund of funds regime in order to authorise the
rebating of expenses to the fund of funds (and, as a quid pro quo, to prohibit rebates to the
management company).
6 ) Investment in unquoted firms through private equity funds
Venture capital funds (FCPRs) and innovation funds (FCPIs) are collective investment schemes
that adopt the legal form of a UCITS and are therefore required to respect the associated
principles. At the same time, they have highly specific features (technical complexity,
management policy, due diligence, investment horizon, etc.) because they invest in unquoted
assets. Accordingly, various aspects of the UCITS framework – period of calculation of net asset
values, risk-spreading rules, liquidity of units, and entrance/exit opportunities – have been
adapted to the sphere of private equity.
A range of legal measures, including tax breaks in the case of FCPIs, have been put in place to
encourage investment in unquoted companies. Funds aimed at sophisticated investors are
characterised by flexible organisation and contractual freedom. By contrast, funds designed for
retail investors are more unwieldy to manage, with a large number of unitholders and broadly
intermediated distribution; and they lay greater emphasis on statutory provisions in an effort to
protect investors.
The current system of management fees results from years of contractual relations between
qualified investors and professional fund managers. Influenced by international trends, those
experiences gradually converged on standard practices.
• The regulations governing FCPRs usually make a distinction between the expenses relating to
set-up, management and custody, and the fees paid to the statutory auditors. For retail funds,
expenses must be easily comprehensible to the general public. The group therefore proposed that
funds open to individual investors, and especially FCPIs, should publish their Total Expense
Ratios.
• The fact that capital gains are shared between the fund manager and the investor plays an
important role in private equity, for two reasons. It brings both parties' interests closer together
and it contributes to the long-term stability of the management company's staff.
It is therefore standard operating practice to create a "carried interest" in the surplus profits of
the fund, whereby 80 percent of the performance reverts to the unitholder and 20 percent to the
management company, the fund managers and the sponsor. This rate of 20 percent, which
reduces the actual performance relative to the gross hurdle rate, corresponds to both the
regulatory ceiling and to international practice. In French private equity funds, carried interest is
evidenced in a special category of unit, part de plus value, or preference share.
For private investors, three areas of improvement have been identified:
− To cope with a diversity of methods of calculating carried interest and with problems of
comprehension among retail investors, best practice could be applied in several areas:
performance-sharing could be calculated net of all expenses; a performance target in the form
of a minimum rate of return could be introduced in certain cases as a trigger for
performance-sharing; standard practices concerning this minimum rate should be harmonised
and aligned on the risks taken by investors; and balanced terms of payment, based on this
rate, should be put in place for beneficiaries of carried interest.
− The subscription price of preference shares varies from one fund to another and is often very
low compared with the price of shares sold to investors. The prospectus must enable the
investor to easily understand the system of preferred shares and the risks run by their holders.
The working group recommends that, for venture capital funds, further information on this
minimum commitment and the way it is shared out among the management company and
retail investors be provided under the code of good practice.
− Investors are not informed about the role of sponsors or promoters. The prospectus should
specify the names of the fund's sponsoring investors (defined as bodies other than the
management company and the staff that own preference shares) and should give details about
their role (for example their investment in ordinary shares) and the percentage of carried
interest allocated to them.
• The working group advocated several improvements in the way that FCPIs and FCPRs operate:
− Transaction and acquisition costs have a much broader definition and greater importance in a
private equity fund than in a general purpose UCITS. The problems that arise when billings
of transaction costs exceed management fees are addressed in the code of good practice, but
a precise and exhaustive description of annual transaction costs should be provided in the
annual report.
− The management company of an FCPR organised as a fund of funds must be banned from
receiving rebates of expenses borne on behalf of the underlying funds.
− When presenting redemption commissions, the liquidity discount reverting to the fund must
be shown separately from the specific remuneration of the fund manager, who is required to
generate the liquidity in order to meet early redemptions.
7 ) Employee savings funds
Employee savings funds (fonds communs de placement d’entreprise, FCPEs) have been highly successful
in France. At end-2001, they had €53.8 billion under management – a rise of 150 percent in five
years – and 5.3 million employee/investors. An FCPE differs from a general purpose UCITS in
terms of fee structure insofar as the expenses are not necessarily paid by the fund but can be paid
partly or in full by the company for which the scheme is run.
Progress in the field of FCPEs should result from the transposition of the working group's
proposed transparency principles for UCITS organised under ordinary law, notably in two areas:
the portion of Total Expense Ratio not covered by the company for which the scheme is run,
and FCPEs invested in UCITS.
8 ) Unit linked life insurance contracts
A substantial portion of collective schemes are now distributed through unit-linked life insurance
contracts. Assets under management in unit-linked life insurance contracts are estimated at
€122 billion, compared with €200 billion in collective schemes held by retail investors.
UCITS offered through life insurance contracts have a number of specific characteristics:
− The contracts are not regulated by the COB but by the insurance industry watchdog, the
Commission de Contrôle des Assurances (CAC). Life insurance contracts are not the only
conduit for distributing UCITS but they do provide a specific legal and tax framework. And
compared with directly held UCITS, they offer a range of specialised services such as death
insurance and switching.
− The information routinely provided to direct unitholders is not systematically supplied to life
insurance policyholders, event though they are exposed to the risks and performances of the
underlying UCITS.
− As consideration for the distribution function, the life insurer receives management fees
rebates – either directly or through a subsidiary – from the firm managing the underlying
UCITS.
The working group noted that this state of affairs, and especially the investor-protection aspects
of it, did not come entirely within its jurisdiction as it currently stands. It therefore recommended
that the debate should continue in another forum, in collaboration with the insurance regulator
(Commission de Contrôle des Assurances) and the relevant professional organisations.