Morningstar Magazine - December 2017/January 2018 - 26

Dispatches

Investors Will
Benefit From MiFID II
GREATER EUROPE

United Kingdom
When the Markets in Financial Instruments
Directive II, or MiFID II, is discussed in the business
press, the focus is on the asset-management
industry's approach to equity research costs.
(Our view is that an investor who is already paying
for active management should not pay anything
additional for research.) MiFID II is much widerreaching, though. There is a raft of new data points
that asset managers will need to disclose,
and they will also need to review their investment
products on a regular basis.
Chapter Three of the Delegated Directive
requires the investment firms of member states
to check whether their own funds are still
fit-for-purpose and relevant for today's investors
and that they offer good value. They will
now be obliged to review their products when
they become aware of an event that could
materially affect the potential risk to investors.
Investment firms must demonstrate that they are
carrying out these checks as part of a "regular
review of products." There is no timeline or
frequency specified in the directive; we believe
a best practice would be to do this at least
semiannually, although it's more likely that it will
be done annually.
All firms would do well to follow the approach
taken by the Financial Conduct Authority
in the United Kingdom. The FCA is adopting a
"gold plating" approach to the directive. It
is proposing to adopt a number of enhancements
to its own regulations from those that have
been set out in MiFID II, with investors' interests
and protection fully at the forefront-the
aim being to ensure best practice. Although the
FCA already implemented changes after the
Retail Distribution Review in 2012, the addition
of new fund data points, such as those
relating to target market and suitability, should
enable advisors to improve the quality of
advice even further.

Morningstar December/January 2018

We like the fact that MiFID II will shift the focus of
product distribution from product sales to the
investor and that the FCA is wholly supportive of
this. Having watched the number of share classes
of funds available for sale in Europe grow at
an exponential rate in the past decade, we hope
that this requirement will eventually lead to
the closure of some relics of the 1980s and 1990s
that still exist, whether because of complacency
among asset managers or investor inertia.
While there may be costs involved in fund closures,
investors will benefit as asset-management
firms take a long, hard look at the funds they offer.
Are the funds relevant? Are they priced
competitively? Does the firm have the right skill
set and expertise to manage these funds well?
However, not all asset managers will fall into the
scope of MiFID II (such as some alternative
investment fund managers and UCITS management companies) and, thus, won't be obliged
to undertake this review.
A further challenge for MiFID II is that, as
a directive, it requires adoption into local law
by each European Union member state.
This may lead to differences among states upon
implementation. We think it's important for
manufacturers and distributors alike to review
funds through the same lens, and have developed
a range of due-diligence scorecards to facilitate
exactly that. For the distributor, best-interest
advice can only be given if it starts with the best
investments, and our Morningstar Analyst Ratings
help identify those. We based our scorecards
on the proprietary five-pillar rating methodology
that underpins the Analyst Rating. This means
a manufacturer can see how its funds are
being assessed by the distributors and pinpoint
flaws such as high fees.
We view price as a key component in a fund's
success or failure, and we welcome the fee
transparency brought about by MiFID II.
Asset managers will be required to break down
costs into four main components: the ongoing
charge; one-off fees, such as entry and exit
fees; incidental fees, such as performance fees;
and transaction fees related to the investment product. This will give investors a clearer
picture of total costs.

The implementation of the Retail Distribution
Review in the U.K. saw a ban on inducements,
meaning investors can now see the cost of
the advice they're receiving, and know that there is
no undue influence on that advice. This isn't
as clear-cut in Europe under MiFID II. For example,
the German government will allow banks' advisors
to continue to receive inducements on the
view that the banks' scale allows them to provide
services and financial advice that their clients
might not otherwise have access to. We wonder
how long Germany will retain this stance.
MiFID II is far more than just a compliance
exercise. At the heart of the directive is
the objective to make investors more informed and
give them higher-quality, more suitable advice.
When the investor wins, we all win.
Jackie Beard, based in the U.K, is director of Manager
Research Services EMEA at Morningstar.

Capacity Conundrum
GREATER EUROPE

Netherlands
Growing demand for European corporate bond
funds is causing capacity-management concerns
within the category. When a fund becomes
too large for its investment universe, it might veer
from its stated investment philosophy when
it makes changes to its portfolio, such as holding
high cash levels or taking positions beyond a
manager's area of expertise. Further, the
bigger the fund, the more difficult it is to quickly
execute trades without affecting market prices.
Academic studies indicate there is an inverse
relationship between the level of assets
under management and the relative performance
of active funds.
Because of extremely low yields on government
bonds-in some cases, even negative yields-
European corporate bond funds have been
particularly popular among investors in recent
years. Demand was further stimulated by
the European Central Bank's quantitative-easing

Table of Contents for the Digital Edition of Morningstar Magazine - December 2017/January 2018