UCITS costs and fees – Central Bank of Ireland’s Dear CEO letter

What’s new?

In January 2021, ESMA launched a Common Supervisory Action (CSA) in order to review practices around costs and fees charged to UCITS. The CSA was conducted by the National Competent Authority (NCA) of each Member State, among them the Central Bank of Ireland (the Central Bank).

Our summary of the aims of the CSA can be found here.

Our summary of ESMA’s findings, published in June 2022 can be found here.

The Central Bank has now published a Dear CEO letter (the Letter) which sets out the Central Bank’s overall findings, examines six key areas of concern and identifies actions it expects firms to take to mitigate these issues.

The Central Bank makes clear that it expects the Letter to be discussed and considered by Boards of UCITS firms and that these take appropriate action without delay.

Those with queries about the Letter’s contents should contact CommonSupervisoryAction@centralbank.ie.

What’s the background to this?

The purpose of the CSA was to assess how far UCITS Managers complied with the cost-related provisions contained in the UCITS framework.

Each NCA examined whether firms, when charging costs to the fund/unitholders:

• complied with the cost-related disclosure provisions set out in UCITS legislation;
• acted honestly and fairly in conducting their business activities, with due skill, care and diligence and in the best interests of their underlying investors; and
• did not charge investors undue costs.

The CSA consisted of three parts:

• a qualitative and quantitative questionnaire sent to firms;
• a desk based review; and
• virtual inspection calls.

In Ireland’s case, 59 firms were asked to complete the qualitative and quantitative questionnaires. Each submission was then subject to a desk-based supervisory review and the Central Bank held virtual inspection calls with 40% of the firms.

While the CSA did not cover AIFMs, the Central Bank notes that it also expects AIFMs to consider the findings in respect of cost and fees charged to AIFs.

What did the Central Bank find?

A. Overview

• Although the CSA did not identify UCITS being charged material undue costs, a number of deficiencies were found where management companies (ManCos) set the cost and fee structure for investment funds. These deficiencies “substantially increase the risk that investors will be subject to undue costs and may negatively impact on investment returns”.
• In setting the cost and fee structure, a firm must act in the best interests of investors and treat investors fairly – this must be evidenced by clearly documented policies and procedures, with clear oversight and approval from senior management.
• Costs and fees charged (and the methodology for their calculation) should be reviewed at least annually, the review being documented and an assessment undertaken as to whether the costs and fees charged to investors remains appropriate in light of:
  • the fund’s investment objective and strategy of the fund;
  • the target and actual level of performance achieved; and
  • the role and responsibilities of service providers.
• Given the key deficiencies identified by the Central Bank (see below), UCITS should make the oversight and calibration of costs and fees a priority for UCITS.

B. Six key findings and expectations

1. A lack of policies and procedures on costs and fees

What the Central Bank found

A “significant majority” of the firms reviewed by the Central Bank were unable to demonstrate that they had adequate pricing governance structures in place.

An absence of detailed policies and procedures governing the calibration and imposition of costs and fees increases the chance that investors will be charged undue costs.

What the Central Bank expects

All firms should have structured, formalised pricing policies and procedures in place.

There should be clear oversight and approval of these from senior management, allowing for the transparent identification and quantification of all costs charged to the fund.

2. Periodic reviews of costs and fees

What the Central Bank found

Most firms reviewed could not evidence that they conduct regular reviews of their UCITS’ costs and fees structure – some fee structures had not been reviewed during the fund’s lifetime.

What the Central Bank expects

All costs - new and existing – must be reviewed annually, taking into account:

• the fund’s investment objective and strategy;
• the target and actual level of performance achieved; and
• the role and responsibilities of service providers.

Throughout a fund’s life, costs and fees must be calculated in a way which is fair and which serves the best interests of investors - and this should be evidenced.

The review should also consider the fund’s viability and competitiveness in terms of being capable of providing a positive return to investors.

Periodic independent reviews of cost and fee structures should also be performed to ensure that investors continue to be offered a return which is commensurate with the fund’s risk profile.

3. Design and oversight of fee structure

What the Central Bank found

In most cases where a firm lacked documented pricing policies and processes in place, it over-relied on assessments made by delegate investment managers to determine a pricing structure of the funds. Some firms had only limited engagement in this process.

This raised concerns on the part of the Central Bank’s that some firms were not giving sufficient importance to setting the cost and fee structures and oversight of the pricing process.

What the Central Bank expects

The reporting of costs and fees by UCITS, and the regular review of these charges, is essential for the proper functioning of UCITS and is in the best interests of investors.

Firms must have clear policies and procedures for the design, oversight and regular review of the costs and fees structures to ensure that these operate effectively and in the best interests of investors.

4. Efficient Portfolio Management (EPM)

What the Central Bank found

Paragraph 29 of ESMA’s Guidelines on ETFs and other UCITS requires all revenue streams arising from EPM techniques (net of operational costs) to be returned to the UCITS.

The Central Bank found that:

• a number of surveyed firms who engage in securities lending programmes retain significantly (30 to 40%) more revenue than their peers from these programmes;
• a significant majority of firms using EPM had no formalised policies and procedures in place covering these activities;
• where firms did have policies and procedures in place, these were generally insufficiently detailed and information in the fund documentation was inadequate to cover the associated requirements and risks for UCITS utilising specific EPM techniques; and
• in most cases, firms could not evidence that they undertook regular reviews of the fees applicable to securities lending arrangements on a planned and systematic basis.

What the Central Bank expects

All fee arrangements with respect to securities lending programmes must be compliant with ESMA’s expectations and clearly disclosed in the fund’s prospectus (or supplements).

They should also be captured in the firm’s policies and procedures.

EPM disclosures within fund documentation should clearly describe:

• the EPM strategy;
• the risks involved; and
• the fee structure relating to the specific EPM techniques, which the fund is using.

Fee arrangements relating to all EPM activities should be reviewed as part of the annual costs and fees review.

5. Fixed Operating Expense (FOE) Models

What the Central Bank found

A number of firms in the Central Bank’s sample for the CSA make use of a FOE model under which the ManCo proposes a fixed rate to cover all of the fund’s running costs. These firms retain excess fees where the UCITS’s expenses come in below the FOE model cap.

In most cases, the FOE was so high that, in almost all circumstances, the firm would have received additional income (in some cases, more than 0.15% of the NAV) as a result of implementing a FOE.

What the Central Bank expects

Where a FOE model is used to provide investors with certainty on fees incurred, the model should be calibrated to minimise any differential and to avoid investors being charged undue costs.

FOE models should be reviewed as part of the annual costs and fees review.

The Central Bank notes that this will be an area of focus in future supervisory engagements.

6. Non-discretionary Investment Advisor Charge

What the Central Bank found

In a number of firms, the non-discretionary investment advisor (IA) was paid a greater fee than the delegated investment manager (IM).

This raises concerns as to whether the IA is also the de facto IM and whether the negotiated fee is in the best interests of the investors.

The Central Bank also queries what it terms the IA’s ‘outsized role’ in the day to day running of the firm – specifically, where the IA is appointed to a fund and is acting with more influence and control than is appropriate.

What the Central Bank expects

The IA’s role should be non-discretionary in nature and an adjunct to the role performed by the IM.

Firms should ensure that fees paid to non-discretionary advisors arrangements are appropriate for the services provided.

C. Action required

1. Firms should calculate costs and fees on an ongoing basis, in a fair and equitable manner which serves the best interests of investors.

2. To address the concerns arising out of the CSA, all firms which manage both UCITS and AIFs should conduct a gap analysis of the findings and expectations above and, where appropriate, put a plan in place to address any gaps identified. They should do this by the end of Q3 2023.

3. Where a firm does not comply with the requirements raised in the Letter, the Central Bank may have regard to the consideration the firm has given to the matters raised in the Letter in the course of its future supervisory engagement.

4. The findings from the Central Bank’s review will inform future policy development and enhancements to the current regulatory framework for the supervision of costs and fees.