Are passives the new benchmark?

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.

Important Note: ATEB news is intended to provide general information ONLY. The content, including any views expressed or guidance provided, does not replace the need to comply fully with FCA Rules and Guidance. Unless you have discussed news article content with ATEB, and specifically how it relates to your circumstances, then ATEB disclaims all liability and responsibility and actions arising from any reliance placed upon it. For the avoidance of doubt therefore, any reliance you place on such information without our consultation is at your own risk.

ATEB Compliance offers compliance and regulatory advice.

ATEB Suitability provides report writing software for the financial services market.

Our View

Don’t believe everything you read is a thought that comes to mind. More specifically, it is not uncommon for a headline to be somewhat different to the story, or that the story is one that is designed to catch the eye – even at the expense of strict accuracy.

All of that seems to apply here. There is certainly an issue to be addressed but it is important to build understanding and processes around the actual rules rather than based on a controversial headline.

ATEB’s compliance service does exactly that. We understand FCA rules and help firms make these work at a practical level. And, because we work closely with the FCA on a variety of projects, we believe we have an up to the minute knowledge of the issues of current concern to the regulator.

Despite the inaccurate slant of the article we refer to here, MiFID II did introduce a number of requirements that we are aware many firms still have not completely integrated into their processes – PROD and the investment / advice process in particular. And firms do indeed need to be able to demonstrate, in the event that a less expensive and/or less complex solution would be suitable, why a more expensive or complex solution is recommended instead.

Having said that, advisers increasingly appear to be moving towards using more passive funds for clients. The primary driver for this is a recognition of the need to reduce overall costs for clients. However, the historical stand off between advisers on either side of the active/passive debate seems to be moving towards passive given the major research done by the FCA that made a very strong case that active funds generally did not provide better net returns when costs were taken into account.

Action Required By You

  • Review your research and investment processes to assess how well they incorporate PROD and the suitability rules, including COBS 9A.2.19;
  • Contact your ATEB Consultant for assistance and guidance or contact ATEB here.
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About the Author

Technical Manager - Often referred to as the Oracle or the Sage, Alistair has a wealth of financial services experience. He is our go-to Technical Manager and enjoys nothing more than a complicated conundrum. Feel free to test his renowned knowledge by getting in touch.

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