Our interest was piqued by an article  that was published towards the end of 2019 under the headline “IFAs told to use passives as cost benchmarks”

The article was reporting on a speech made by an industry commentator and was of interest not least because it was news to us.

The headline is very specific and of significant impact – if only it were true … which it isn’t!

More accurately, the statement is true but the implied meaning is not. It is a fact that the speaker TOLD IFAs they should consider passives as a benchmark but the headline implies that he was quoting some absolute rule requirement rather than merely offering his interpreted opinion. That would be misleading even if the interpretation were correct, which it isn’t.

The article starts with: 

“Rules introduced by Mifid II mean advisers need to use passive funds as a cost benchmark for investment suitability, according to Mike Barrett, consulting director at The Lang Cat.

Speaking at the company’s DeadX conference in London, Barrett said the rules set out in the regulator’s Conduct of Business Sourcebook 9A.2.19 means IFAs must compare the investments they are recommending against a lower-cost option, such as a passive fund. Barrett believes these rules have been overlooked by the advice community.” 

As can be seen, the headline claim is already being softened as early as the second paragraph – the reference is now to lower cost options of which passives are merely an example.

The rule that is referred to, and which is a direct lift from Article 54(9) of MiFIDII is: 

COBS 9A.2.19 EU 03/01/2018

Adequate policies and procedures: MiFID business

Investment firms shall have, and be able to demonstrate, adequate policies and procedures in place to ensure that they understand the nature, features, including costs and risks of investment services and financial instruments selected for their clients and that they assess, while taking into account cost and complexity, whether equivalent investment services or financial instruments can meet their client’s profile.

Although this specific rule was introduced as part of MiFIDII in January 2018, it is essentially no different to what suitability rules have always required … namely due consideration of the nature and features of different solutions and a subsequent selection of a solution of a nature and with features that meet the client’s objectives and circumstances. Costs and complexity are of course undoubtedly two of the key factors that should be considered.

The interpretation of the rule by the speaker was based purely on a consideration of costs and, all other things being equal, a passive version of an ‘equivalent’ active fund is likely to be cheaper and so would appear to be a no brainer choice. Indeed it would be. But the comparison is flawed in that such a similar active fund would in fact not be an active fund but would be a closet tracker with higher costs! In practice, beyond the unacceptable world of closet tracker funds, active funds and passive funds have fundamentally different characteristics and each arguably has a part to play in a portfolio that is suitable for a particular investor.

So the key word in the rule is ‘equivalent’. Equivalence varies from client to client. Other factors are often relevant for particular clients. For some clients a more expensive solution will be suitable because one or more of those other ‘non-cost’ factors indicates so.

Finally, it is not all about cost. Complexity should also be a consideration. The FCA has commented about advisers using solutions that are more complex than is required or appropriate. Does the client need a SIPP or would a Personal Pension be adequate? Is there a benefit to the client of investing via a platform or would a direct investment into a portfolio of funds be more cost effective? Another issue here is that more complex solutions are often accompanied by a need for clients to agree to ongoing service and that has an indirect impact on costs over time.