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Graham Bentley: Why all advisers must adopt Mifid II 10 per cent warning rule

As it stands, only discretionary fund managers will have to report a fall in a portfolio’s value of 10 per cent or more

In a freak accident, the UK’s jewel in the regulatory crown – treating customers fairly – has been trampled over by the EU.

Mifid II’s ill-fitting ensemble of new rules contains a proviso that portfolio managers with discretionary powers must report within 24 hours any fall in a portfolio’s value – since the beginning of a quarterly reporting period – of 10 per cent or more. Subsequent 10 per cent falls within the same reporting period must also be communicated.

There is a danger this almost purposeful ignorance of UK retail investment management practice will allow an Orwellian regulatory landscape to develop, where all investors will be deemed to be treated fairly but some more fairly than others.

I am not concerned with reporting per se. The DFM is accountable for reporting. The UK’s preference for managing model portfolios over bespoke (quite literally a foreign concept from the EU viewpoint) means the discharge of notification responsibility must tumble through platforms, with the unwelcome message crashing in the laps of advisers within 24 hours.

Platforms pledge to help advisers with Mifid II rules

Those platforms that cannot promise to facilitate the process will effectively wave goodbye to that model portfolio business.

Do not imagine this is about TCF, by the way. Bizarrely, the insidious impact of serial, significant (for example, 9.9 per cent) falls across consecutive reporting periods need not be reported. Quarterly falls of more than 10 per cent that do not fall inside the “official” reporting period need not be communicated either. And yet the many holes in the 10 per cent rule are being tissue-papered over with the feeble excuse that it is a rare event, so why worry?

Since its formation on 10 April 1962, there have been over 14,000 daily index returns on the FTSE All-Share index (as at 17 November). Assuming reporting periods are standard calendar quarterly, there have been 223 of these and, on a total return basis, 23 of them had a fall in excess of 10 per cent.

Since portfolio valuations incorporate associated fees not accounted for in an index (for example, annual management charge, adviser charging and a platform fee), one could reasonably allow for an additional 50 basis points deduction for quarterly fees. However, this adds only one more instance.

In other words, on the calendar measure, the 10 per cent downside event has happened on average once every 30 months, the last being in Q3 2011 when the market eventually fell by over 16 per cent. Of course, markets do not keep to a timetable: during the mid-1970s the index fell by an arithmetic average 20 per cent per quarter for five consecutive quarters.

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Definitively, investors can go into the market on any business day, not just the first of January, April, July and October. By looking at daily rolling three-month periods, one finds these downside events are much more prevalent than calendar quarterly data indicates.

Over the life of the index, over 1,000 occasions saw falls greater than 10 per cent over 65 consecutive business days. When total charges of 50bps per quarter are applied, the number increases by another 80. Now, of a little over 14,000 observations, 1,200 would be potential notification events. Indeed, the most recent was 11 February 2016 when the market had fallen by over 11 per cent in the preceding three months. In other words, under a “constant watch” scenario, the probability of a notifiable event rockets.

So it happens more often than you might imagine, and to every investor exposed to equities. Some may argue that since most portfolios are diversified into bonds to some extent, the 10 per cent drawdown is less likely. That depends on their assumptions about future bond returns, bearing in mind 35 of the 55 years of data saw bond prices rising as the discount rate plummeted – a scenario unlikely to be repeated.

However, the most Kafkaesque aspect of this directive is the fact advisory model portfolios are not subject to these requirements. The EU regulator ESMA and other European national supervisors are utterly unaware of the peculiar position in the UK, where advisers of all investment faiths are allowed to run model portfolios on a non-discretionary basis, and where such a service is specifically designated not to be investment management.

Are DFM clients worthier of notification than clients invested in advisers’ in-house model portfolios? Of course not. To hide behind regulation in order to neglect the best interests of one group of clients versus another would be disingenuous to say the least, and against the spirit of TCF being at the heart of an adviser’s business.

Regulation overload: Are advisers ready for the Mifid II mountain?

This is not about doing just enough to satisfy a regulatory rule – it is about doing the right thing. The 10 per cent rule is fundamentally flawed, drafted without an understanding of the rather idiosyncratic way investment management operates in the UK.

Advisers need to consider informing any client – advisory or DFM-linked – of any such fall. Consequently, advisers running model portfolios might like to challenge their associated platforms to inform them of 10 per cent falls on a daily rolling quarterly basis for both advisory and discretionary clients.

That is clearly not an insignificant responsibility but given the ongoing FCA platform market study (and since the client is paying the platform a significant sum for services) this is an opportunity for them to demonstrate they are truly providing a service aimed squarely at investors, as well as advisers.

Graham Bentley is managing director of gbi2


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There are 8 comments at the moment, we would love to hear your opinion too.

  1. Or what about sticking with TCF, agreeing a reporting strategy with clients, and sticking to it through thick and thin. And along the way ignoring the ‘fundamentally flawed’ new regulation since it doesn’t formally apply to us.

    I get that the regulation is designed to ‘unsettle’ customers, and get them to challenge their investment manager – but beware of unintended consequences. Unexpected and poorly understood bad news tends to promote fear. Fear promotes either panic or inaction – often one then the other.

    So my prediction is that this specific regulation will at best fail to make an impact, and at worst promote capitulation – which would harm long term retail investor outcomes.

    I see little reason to adopt this unless required to.

    The great news is that if I’m wrong, we can always jump on board later.

  2. Which way did you vote in the referendum Graham? “Trampled over by the EU” is a bit emotive don’t you think.

    I would hardly call Treating Customers Fairly a “Jewel in the regulatory Crown”. I don’t see that, given the expectation that advisers would act ethically towards their clients, merely giving that a name (TCF) will have made that much difference. Especially with so many reports of advisers exaggerating their qualifications. If TCF is regarded as the best thing the FSA ever did that probably shows why they also ended up giving us the RDR.

  3. As with almost all of MIFID ii my ultimate feelings are that of ‘so what’. By the time a 10% change has occurred, been identified and reported to the client, the 10% may well (probably)have changed again to +/- a different percentage.

    And what will a client then do, be euphoric as its a buying opportunity or panic and sell at a loss?

    Good value for the regulators but of none to those who are paying for it!

  4. It shows how disconnected form reality the EU regulators really are. Yes, it should apply to all advisers and not just DFMs – well, actually it shoudl apply to none as it is a crass requirement – any adviser worth his salt already contacts clients during significant market downturns. What about transaction reporting and LEIs? Two other stupid requirements that could be covered so easily in different ways – and in this instance, Investment Trusts are being unfairly treated compared to unitised holdings – which should all be included – or really, none reported by DFMs at all – that is what the market is for. Forget EU prejudice – it is a shame we were not out already….

    • It’s perfectly OK for you to give an opinion on the EU, Philip, but I don’t think that someone writing an article in Money Marketing should be making comments that seem anti EU. They should just stick to writing the article.

      Being out of the EU would be fine with me, if I were only considering the effect on my job, although there is no telling what our own regulator would come up with, on their own (RDR anyone). And I’m sure this government would be grateful if you could let them know how to get out without leaving at least one border open (that’s not bringing back control). Or having all hard borders and wrecking the good Friday agreement, therefore leaving the way open for a reemergence of violence and bombs on the streets of Ulster and in mainland Britain as well.

      Oh, and let’s not blame the Irish for this mess. The DUP are British. They are just trying to shift the balme.

  5. Regardless of the other holes in it, to my mind even in this article the most glaring hole of all doesn’t seem to be recognised.

    Which is that each client is different. Each client has different goals, different risk tolerances, different capacity for loss etc.

    To a higher risk profile client who knows what they are investing in is volatile, all this does is drive a potential wedge into the discussions with them. “sorry the EU/FCA make us tell you this information we know your not concerned about”. Whilst a low risk client to whom 2 or 3 consecutive 9% falls in value would be a total disaster, isn’t even required to be told.

    A one size fits all mandatory glove makes a total mockery of the entire thing.

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