Marketforce and the IEA’s 11th Annual Conference
THE FUTURE OF FUND MANAGEMENT
Wednesday 24 March 2010
Director Conduct Risk
Asset Management Sector Leader
Financial Services Authority
The Future of the Fund Management Industry:
An FSA Perspective
Good afternoon ladies and gentlemen. Thank you for your invitation to speak here
today. I have been asked to speak about the FSA’s perspective on the future of the
fund management industry. There is a great deal that could be said. In the time
available, I will limit my remarks to a few key issues. I will be happy to take
questions and comments at the conclusion of my remarks.
First, I will discuss some of the key messages for the asset management sector that
we highlighted in our recent Financial Risk Outlook (FRO), which was published two
weeks ago. Second, I will offer our developing view of what is often referred to as
product regulation in the retail funds and wider investments market – with an
emphasis not on product approval, but what I would call product scrutiny: a clutch of
issues around product governance, design and continued oversight by product
providers. My final topic this afternoon will be the wider European regulatory
landscape. I will focus on the Commission’s work on Packaged Retail Investment
Products, developments occurring in the Undertakings for Collective Investments in
Transferable Securities (UCITS) regime, and last, but by no means least,
negotiations on the Alternative Investment Fund Managers Directive (AIFMD).
1. Key messages from the Financial Risk Outlook (FRO)
Since the publication of last year’s FRO, the immediate financial crisis has subsided,
equity and credit markets have recovered, and most major economies came out of
recession in the last quarter of 2009. But this recovery was possible only as a direct
result of the public policy response – quantitative easing, bank recapitalisations,
exceptional central bank liquidity support and so on. And yet despite these
measures, most developed economies, including the UK, suffered a severe
recession in 2009. Indeed, the UK economy experienced its largest annual
contraction in GDP since the Second World War. Recovery is still fragile and many
vulnerabilities remain as a result of the leverage built up during the boom years.
Even a fragile recovery, however, saw a significant improvement in results for the
majority of asset management firms after a dismal 2008. In particular, specialist
equity managers and hedge funds experienced a sharp rebound, supported by
strong growth in equity markets.
Certain trends in the industry continue, such as the expansion in the use of
derivatives in investment strategies and the increasing complexity of products
offered to investors. These, in turn, require firms to have more sophisticated controls
over investment risk and internal operations. Firms must consider whether complex
strategies are appropriate for the customers they serve, as there is a risk that firms
pay insufficient attention to these questions as they seek to exploit rising demand for
In the FRO we highlight four key risks in the asset management sector. I will focus
first on two of these – controls over client money and assets, and valuation of assets.
I will be discussing another – the AIFMD – more fully later in my talk. Another key
area we address in the FRO – the complex set of issues around platforms – I will not
speak on today. Our Retail Distribution Review (RDR) Policy Statement and a
Discussion Paper on platforms are due to be published this week, and I don’t intend
to give any detail ahead of that.
We consider the protection of client money and assets to be fundamental in
sustaining consumer confidence in firms in the sector, and we have set out detailed
rules in the Client Assets Sourcebook or CASS. This means ensuring that
customers’ money and assets are safe, and remain safe even if an asset manager
becomes insolvent. We are concerned that firms’ controls over client money and
assets do not always achieve the appropriate level of protection. Failure to comply
with the basic requirements of CASS may result in customers losing money through
theft or because their assets become comingled with firms’ assets. Firms must be
able to demonstrate that they understand and are in compliance with their
obligations regarding the protection of client money and assets and this is a
supervisory priority for us.
Under the Collective Investment Schemes Sourcebook or COLL, asset managers
are responsible for producing fair and accurate valuations for authorised funds, a
responsibility they sometimes delegate to fund administrators. For unauthorised
funds, responsibility for valuations is a matter of agreement between investors and
the asset manager, with responsibility often allocated to the fund administrator.
How assets in a fund are valued, impacts the investment performance calculation,
the setting of prices at which investors buy and sell units in funds and the fees of the
asset management firms. We view robust and reliable valuation of assets as an
essential part of the management of clients’ portfolios and collective investment
schemes. Failure to value assets correctly could result in litigation or reputational
damage to firms and reduce consumer confidence in asset management products.
We continue to have concerns over the reliability of valuations, especially relating to
illiquid and complex instruments, including overthecounter (OTC) derivatives.
Illiquidity in the underlying market and an absence of reliable prices has made
valuing fixed income instruments and property investments difficult. Valuation has
also been difficult where there has been disparity in the valuation methodologies for
Those responsible for valuing assets should have adequate expertise to take a view
on the fairness and accuracy of all valuations, including conducting sense checks
and challenging any valuations that do not seem reasonable. Robust governance
should exist over the systems and controls used to produce valuations, and there
should be procedures to compensate investors if inaccurate valuations occur. The
asset management sector team is working closely with the supervision line to ensure
this issue remains in the forefront of fund managers’ minds.
2. The investment value chain and product governance, design and
My second topic this afternoon is the FSA’s increased focus on what I will call
product scrutiny: that is, a group of issues around product governance, design and
As we highlight in this year’s FRO, investors appeared to recover some of their
appetite for financial risk during 2009, particularly in the retail sector. On the back of
low interest rates and changing perceptions of value, retail investors put more money
into the retail funds sector than in any previous year. They favoured corporate bond
and absolute return sectors in particular, also with a strong showing by the property
sector in the final quarter. Generally speaking though, the resurgence of the funds
market has been relatively broadbased and would seem to provide a strong platform
on which to build. Sustained growth in the funds industry is likely to come not only
from the sale and retention of holdings in existing products, but also through the
introduction of new products. Fund managers have a particularly important role to
play here, for example, in the decumulation market. Many investors close to
retirement have been particularly affected by the current downturn. Many are facing
the prospect of much lower retirement incomes than they expected a few short years
ago. Their pension pots are typically much smaller than they were and pension
annuity rates have fallen steadily to an all time low.
In responding to these and other pressing consumer needs, we anticipate that
innovation in fund management products will come about both as a result of product
development at established, traditional firms, as well as through the arrival of new,
regulated product providers, including from other parts of the market. A key
facilitator for product innovation is increasingly proving to be the broad flexibility of
regulated fund forms available to managers. In Europe, and indeed globally, UCITS
III is providing fertile ground to new entrants in the retail funds market, such as
hedge fund managers. I would also highlight the expansion of our domestic retail
funds regime to include Funds of Alternative Investment Funds.
This flexibility means, for example, that access for a significant proportion of hedge
fund managers active in the UK and elsewhere to the broader spectrum of traditional
fund management clients is achievable, if not already a done deal. While we
welcome firms that may bring fresh and useful thinking to the retail funds market, we
would remind new UCITS managers that compliance with the UCITS framework is
likely to require investment in systems and controls to meet the specific requirements
of these highly regulated structures. Similarly, while asset managers may delegate
various functions, they retain ultimate responsibility for compliance with the quite
detailed requirements of UCITS III and, even more, under UCITS IV.
With increased momentum in the proliferation of new investment strategies in
familiar wrappers, we return inevitably to concerns about how we identify whether
the retail market operates in such a way as to deliver products that address real
consumer needs and deliver good consumer outcomes. In a retail market where
consumers struggle to understand their own needs and to assess value for money in
their product purchases, this is a perennial challenge.
Historically, the FSA’s approach to this has been transactional in nature: we have
focused on point of sale disclosure, suitability, sales processes and other
requirements applied towards the end of the product lifecycle of development,
marketing, distribution and postsale services. As we have seen in the investment
market and elsewhere, there are several limitations to this approach. Critically, it has
ended up being too often reactive in application, and has not enabled the FSA to
prevent some major product risks from crystallising.
To put it bluntly, there have been too many misselling scandals in the UK and we
want to turn the page on that part of our history. That is a key personal priority for
me as the FSA’s Director of Conduct Risk. We are developing and delivering a
regulatory approach that looks more deeply into the value chain and the product life
cycle, into product scrutiny around governance, design and oversight by provider
So how do we go about doing this? As you may know, one of the major changes
introduced in our supervision enhancement postNorthern Rock has been a much
deeper understanding of firms’ business models, to identify the core strategy and the
drivers of income and profitability going forward. As a regulator, we need to be far
better informed about where the industry is and where it is going next in response to
market and regulatory developments and assess what risks to consumers may arise
from firms’ responses to these factors.
As a result of this, we are focusing increasingly on the whole investment value chain
including upstream processes – product development and design – as well as
downstream activities – marketing, distribution and postsale handling. We also
want to ensure that firms have the right incentives at each step in the value chain to
produce products that add value and address real consumer needs. Put another
way, we are particularly interested in identifying products which we think are
produced with little consideration as to the likely benefits that will accrue to the
customer, and where much more attention has been paid to the value that will be
added for the firm by introducing them.
Our focus will be on testing what outcomes consumers experience from the products
firms sell them against our principles in a systematic and objective way, integrating
these assessments into our existing supervisory framework. Obviously, the
’outcomes’ that consumers experience inevitably reflect product design and
governance considerations, but also the messages that are relayed to those
investors or to their advisers, about the right use and purpose of those products.
As we signalled in our January 2008 good practice guidelines for operators of UK
authorised Collective Investment Schemes (CIS), we are also very interested in risks
arising through providers’ direct contacts with distributors. In our view, it is
incumbent on providers to explore and understand their distributors’ information
needs and ensure, as far as possible, that distributors are getting the right messages
about what particular products do and how they might reasonably be used. This
may be especially challenging for those firms that do not have deep experience of
working in the retail market.
I would at this point say that we do not see our enhanced interest in product scrutiny
as a step in the direction of increased retail product approval or design by the
regulator. Rather, our focus is on ensuring that there is appropriate alignment of the
interests of product providers and distributors with the underlying needs of investors.
3 The European regulatory agenda for funds
Let me turn now to my third and final topic: the regulatory landscape for European
funds. I will touch briefly on three principal areas, the Commission’s work on
Packaged Retail Investment Products, developments in the UCITS regime, and the
In delivering retail investment propositions, competition between the sectors
(structured products, insurance products and funds) is nothing new. We in the UK
have operated a 'packaged product regime' for some time, one of the principal
purposes of which was to create a level playing field between retail products
produced across the sectors. We preserved that level playing field in our
implementation of Markets in Financial Instruments Directive (MiFID), largely reading
across the MiFID requirements to life insurance products with an investment
element. The level playing field was further strengthened through our
implementation of the new Conduct of Business regime for banking, which makes
clear that structured deposits are also captured in our general approach.
The European Commission, pushed hard by the European funds industry, has
launched an important examination of the effectiveness of regulation of retail
investment products across the banking, insurance and fund sectors, with a
particular focus on the rules around selling processes and precontractual consumer
disclosures. Essentially, these proposals aim to introduce a level playing field for all
investment products sold in the European retail market, irrespective of their legal
form. The Commission has dubbed these products ‘Packaged Retail Investment
Products’ (PRIPs) in order to distinguish them from straight securities.
There is still some work to be done here to determine which products are genuinely
substitutable. We are working with the Commission and Level 3 committees to
reach a conclusion as to which products are within scope. The Commission’s
preparatory work on the dossier is not yet complete, but there are likely to be two
main strands: a requirement for a simple product disclosure document (which may
look similar to the new UCITS Key Information Document); and standardised
conduct of business rules (which will be based on relevant MiFID requirements).
We think that the fund management industry should be wellplaced to work under
this new regime. In particular we would anticipate changes in the way you compete
with other types of retail investment products in the panEuropean market. The
philosophy of PRIPs is that across Europe all products that offer similar investment
goals will become subject to the same standards. From our perspective as a single
regulator, we see clear benefits to consumers from a more consistent crosssectoral
approach and we are fully supportive of the Commission’s work in this area.
Meanwhile the UCITS IV package of reforms is slowly coming to final fruition, with
the European Council and Parliament agreeing the socalled ‘level 2’ package of
detailed measures, on which the Committee of European Securities Regulators
(CESR) provided advice to the Commission. The FSA was an active participant in
these discussions, chairing one of the working groups and cochairing another, on
the key investor information document, with the French regulator. We hope the
measures will be adopted by the end of June, leaving a year for national
implementation of the necessary measures. The FSA, and also we expect HM
Treasury, will issue consultation papers later this year.
Looking at the substance of the reforms themselves, and the potential future effects
on the fund management industry, as you know one of the drivers for the reform
package was to allow greater exploitation of economies of scale to reduce costs to
investors. We have heard a mixed reception from industry to the proposals
regarding fund mergers - although this is the most obvious way to rationalise fund
ranges and increase fund size, there remain genuine unanswered questions about
the tax treatment of crossborder fund mergers. CESR noted this as an issue in its
advice and we hope that if this does prove to be a major stumbling block in practice,
the appropriate measures can be taken to rectify the situation.
There has been more positive discussion of the scope for use of master/feeder
structures and the improvements in the notification procedure.
As you will know, the management company passport was the most controversial
part of UCITS IV, not being contained within the original Commission proposals. We
have heard caution from you on this point - no one necessarily likes to be the first to
take advantage of such a new feature. An important part of making this work will be
good cooperation between home and host supervisors.
Finally, a word about the Key Information Document (KID). KID requires that the key
information about a fund be captured in two legible sides of A4. Please don't put
your legal departments in charge of drafting these documents! At level 1 we have
provided for a form of 'limited liability' in respect of the contents. We believe that the
KID is a real opportunity to demonstrate that disclosure can work for the benefit of
investors. As I mentioned earlier, similar documents are likely to evolve for other
products as part of the Commission's PRIPs initiative. The presence of a numerical
rating based on volatility is a controversial aspect of the KID, and as you probably
know the FSA has generally taken a sceptical view of the success of creating a
single focal point for consumers which they may take to summarise all the risks
involved in investing. We recognise, however, that the balance of opinion within
CESR and across most commentators was for such an indicator, combined with
some narrative explanation of risk; so we are committed to making this work.
And the future for UCITS beyond this? Well, we are clearly expecting legislation
from the Commission on UCITS depositaries, following their extensive consultation.
There will undoubtedly also be feedback from the final form of the AIFMD,
concerning the presence or not of differential standards for retail and professional
investor funds. Perhaps there may be a move to extend UCITS eligible assets to
include real estate, and even commodities – the two major asset classes outside of
UCITS that retail investors can currently access through national retail fund regimes
that will now be subject to the AIFMD. Added to all that, there will be a number of
areas within UCITS IV where the new European Securities and Markets Authority will
be encouraged - or made - to adopt binding technical standards to realise a more
harmonised approach to implementation of the Directive. So the journey will
I want to finish today by turning to the Alternative Investment Fund Managers
Directive. As most of you will be aware, this Directive was proposed by the
European Commission last April to strengthen the regulation of the nonUCITS fund
management industry across Europe.
Much has already been said in various fora about the provisions of the Directive, so I
do not intend to cover the detail of the Directive here. Instead I will comment on
where we have got to in negotiations.
As most of you will be aware, the Spanish Presidency of the Council of Ministers had
intended to present its compromise proposal on Tuesday of last week to the
Economic and Financial Affairs Council (ECOFIN) – which is comprised of the EU’s
Finance Ministers. The Spanish had intended to achieve what is known as a
‘general approach’. This is a nonlegally binding mandate from the Council of
Ministers to the current holders of the Presidency to negotiate with the European
Parliament and the Commission in trialogue discussions to finalise the directive.
In an effort to get further agreement among Member States, the decision was taken
by the Spanish shortly before the ECOFIN meeting to remove the discussion from
the agenda. The Spanish did however reiterate that getting agreement on the
Directive was a priority during their tenure as President, so we can expect to see a
further discussion and most likely a vote in the Council sometime before the end of
The deferral of the ECOFIN discussion will enable the European Parliament – which
is debating the Directive alongside the Council of Ministers – to take the lead for the
first time during the process. The Committee on Economic and Monetary Affairs
(ECON), in which the bulk of the Directive is being debated, has held two
considerations of the record 1700 amendments proposed by MEPs to the
Rapporteur, JeanPaul Gauzès. Mr Gauzès is preparing his final report, which will
outline the amendments to the original Commission proposal. The ECON
Committee vote, which was scheduled for 12 April may be delayed by a couple of
weeks, but should be held before the end of April.
Mr Gauzès proposals differ in a number of respects from the version of the Directive
that has been produced by the Council of Ministers. One of the starkest differences
is in respect of the so called ’third country aspects’ of the Directive which deal with
the treatment of funds and fund managers based outside of Europe. Notably, the
proposals Mr Gauzès has put forward envisage that after a transitional period (the
length of which is being debated), and subject to certain equivalence criteria being
met, a marketing passport would be granted to those fund managers either
established outside of Europe or managing funds which are established outside of
The FSA has always supported the principle of the marketing passport to replace the
patchwork of the national private placement regimes that currently exist across
Europe. We have also accepted that in order for third country fund managers to
obtain such a passport, equivalence criteria should be met. Crucial questions
remain, however, as to the content of the standards against which equivalence
would be judged and by whom the decision would be made. Given the global nature
of the alternative investments market, our view remains that we must create a
proportionate, effective and worktable regulatory approach that recognises the reality
that alternative investment fund management – including its support services –
inevitably involve markets and jurisdictions across the globe and not just in Europe.
This global point of view is shared by Commission President Jose Manuel Barroso
who has previously said that ‘financial markets are European and global, not only
national’. It is also shared by Mr Gauzès, who has acknowledged very publicly in the
Parliamentary debate that ‘the EU should not be a fortress’ and should avoid ‘closing
the door’ to nonEU funds.
It is important to strike the right balance here to deliver sensible standards and
equivalence criteria. There is, moreover, an important question about the
consequences for a third country failing to make the grade. Unfortunately, in this
regard, some of the proposals put forward by Mr Gauzès are worrying and could
have an adverse effect on future alternative investment flows into and out of Europe,
an outcome we think undesirable.
Firstly, in instances where third country jurisdictions are not deemed equivalent, Mr
Gauzès envisages that fund managers would be prohibited from marketing their
funds on a private placement basis. Secondly, and of greater significance, is Mr
Gauzès’ proposal in instances where the alternative investment fund and its fund
manager are based outside Europe. In these cases where the third country
jurisdictions are not deemed equivalent, Mr Gauzès envisages that even investment
into the fund made at the own initiative of the investor would not be permitted.
Such a draconian prohibition has been strongly objected to by institutional fund
managers, who view it as limiting legitimate choice and damaging investor returns.
The market impact analysis undertaken by Charles River Associates showed that the
reduction in investment returns to European institutional investors, such as pension
funds were one of the most damaging effects of the original directive’s proposals.
Moreover, from a regulatory policy point of view, these provisions are about as
overtly protectionist as could be imagined. Indeed, similar elements of various
versions of the Directive have already drawn the attention and criticism of the US
Treasury Secretary. One has to ask what would be the outcome if our major trading
partners sought to follow a similar policy; that is, attempting to force their own
regulatory standards upon us and upon other jurisdictions as a precondition for
crossborder trading. It is apparent that this autocratic approach is as antithetical to
fundamental principles of the free movement of capital as it is contrary to the core
principles of regulatory cooperation in economic matters that is embedded in the
work of the G20.
I will conclude my remarks on the AIFMD by reiterating what I have said previously;
namely, urging the Council of Ministers and the European Parliament not to act in
haste on these complex and important matters. The decision by the Spanish
Presidency to defer the decision on the Directive in ECOFIN is to be welcomed. It
affords muchneeded additional time for further work, particularly on the important
and sensitive matter of third countries. I urge Mr Gauzès and the Parliament to
exercise similar caution and not to rush to judgment on these critical issues. The
AIFMD presents an opportunity to create a regulatory framework which enhances
the stability of the financial system while at the same time encouraging sustainable
economic growth and development across the EU. It is worth taking the time to get it
I am conscious that I have sought to cover a lot of ground today, but I hope I have
left some time for some questions. Thanks very much for your attention.