Asset managers may have to raise the total expense ratios on their funds as the cost of regulation is squeezing their margins. Stefanie Eschenbacher reports on the cost implications of Ucits V and the Alternative Investment Fund Managers Directive.
Total expense ratios (TERs) are set to rise, as asset managers can no longer absorb the additional cost of regulation solely by improving operational efficiencies.
Data by Morningstar shows TERs for funds in Europe have fallen over the past years, despite post-financial crisis regulation squeezing their margins.
There is, however, only so much asset managers can absorb.
One of the most fraught issues is the effect of potentially higher depositary costs as both the Alternative Investment Fund Managers Directive (AIFMD) and the Ucits V rules contain a requirement for custodian banks, the providers of depositary services, to be held strictly liable for the restitution of assets.
This has increased the banks’ business risks and a resulting increase in costs for certain funds has long been warned of, particularly where the risk of losing assets is higher than normal, perhaps due to strategy or political risks.
David Micallef, chief operating officer, European trust and depositary services, at BNY Mellon, confirms there is potential for some funds to become more expensive. “A number of banks, including our own, refuse to take restitution liability for certain markets. We have ten markets for which we will not accept restitution liability.”
Custodians have warned in the past that where risks are particularly high, they simply may not be prepared to provide depositary services.
Micallef says those are the “really exotic” ones, typically in parts of Africa and the former Soviet Union where there are highly unsophisticated markets, political instability, and an immature financial services industry or where the regulations do not offer protection for assets.
BNY Mellon declined to name the ten markets.
“We are not saying you cannot go into these markets; what we are saying is that we cannot guarantee the restitution of assets in those markets.”
Micallef says that at the onset of regulatory change, investing in emerging and “exotic” markets was expected to become cost-prohibitive. “It has not quite turned out like that,” he says.
Charges for Ucits funds have decreased, which Micallef says is because asset managers have had to become more efficient in their internal organisation and the way they manage distribution.
But he estimates that fees for some funds could increase between 200 and 300 basis points.
As well as custodians, distributors and other service providers, like fund administrators, have also experienced cost pressures.
“People have realised that they need to reduce costs,” Micallef says. “The other thing that has helped is that assets are increasing.”
He says this is diluting fixed costs, like fees for fund accounting, transfer agents, lawyers and auditors.
Jon P. Griffin, managing director of JP Morgan Asset Management, says asset managers have had to absorb the cost of compliance.
“We certainly have not passed that on to our investors,” he says, adding that the costs associated with the Foreign Account Tax Compliance Act will also have to be absorbed.
He does not expect competitors to leave the market as a result of cost pressures.“There is so much change and regulation to implement that the focus is on getting it done and getting it done properly,” he says. “All eyes are on Ucits V” for equivalent or higher standards than in the AIFMD.
“As the AIFMD rolls over into Ucits V, we expect that the depositary banks will pass on additional costs for Ucits.”
The Ucits IV directive also brought techniques like the master-feeder structure, management companies and the possibility for cross-border mergers.
These have created economies of scale for some asset managers.
Martin Bock, director, advisory and consulting at Deloitte, says asset managers are looking carefully at what they can do internally and what they can outsource, especially when it comes to reporting.
“There is a strong trend towards outsourcing,” he adds.
He says the cost of reporting is high when done internally, compared to finding the best external provider.
“Another element that should not be forgotten is that regulation does not just mean constraints and additional costs.
“It also brings opportunities so asset managers can create new products and reposition themselves to generate more returns, which helps to absorb the costs of regulation.”
Bock adds that cost is not the only criteria for investors because if it were, everyone would be choosing exchange-traded funds.
Research from Morningstar Denmark shows that investors in Luxembourg-domiciled share classes, which collectively hold the most assets in any European domicile, pay among the highest ongoing charges in Europe on an asset-weighted basis. Nordic-domiciled share classes sit on the other end of the spectrum.
Laurent Fessmann, partner at Baker & McKenzie, says funds based in Luxembourg tend to be cross-border products that are distributed in at least five different countries.
The cost for these funds is higher because of the distribution network and multiple share classes to accommodate investors’ preferences, for example for certain currencies.
Fessmann says the prices in cross-border domiciles may be regarded as higher than in domestic markets, but there tends to be more choice.
“Global fund distributors will also argue that it is easier to distribute Luxembourg-domiciled funds worldwide than, say, a fund domiciled in Italy,” Fessman says. “It is the brand.”
There is a marketing argument to having a Luxembourg fund, Fessmann says, but operations and tax neutrality are also important considerations.
Tax neutrality does not mean that investors do not have to pay taxes; they do, but in principle they are not taxed at the level of the fund.
While fees are set to increase, they have actually declined over the years. Still, they are well above those in the US.
Geoffrey Cook, partner, and co-head of investor services for Europe, Middle East and Africa, at Brown Brothers Harriman, highlights the structural challenges of the European fund industry, which charges several basis points – up to double or triple, depending on who they are sold to – more.
One of the reasons for the different fee structures is simply the economics of the European fund industry, which has broadly similar types of total aggregate assets than in the US, but with up to ten times as many funds in the universe to sell.
Morningstar’s research also found that a typical investor in European equity could save 20% in ongoing charges by choosing a large share class, or a large fund company relative to a smaller one. The savings were even more significant for fixed income investors.
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