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.
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.
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.
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