MiFID II – Costs & Charges Disclosure (Or: How I learned to balance complexity with clarity)

On a recent client project, I was introduced to the exciting world of regulatory legislation through the Markets in Financial Instruments Directive II (MiFID II). MiFID II is an EU-wide directive which governs the trading of shares and other financial instruments conducted by organisations within the EU.

MiFID II is in fact a replacement for the original MiFID rules, released in November 2007. This earlier MiFID is not viewed as an overwhelming success, due at least in part to its concurrence with the financial banking crisis of late 2007. The original MiFID also focused primarily on equities, while MiFID II is much broader and has a more wide-ranging scope.

MiFID II encompasses all aspects of trading assets within the EU. Currently, it appears that insurance services will be subject to the original MiFID rules.

One of the key elements of the MiFID II rules is greater transparency to investors with regards to costs and charges applied on holdings.  My project, and therefore the focus of this article, relates to this aspect of the directive.

These costs and charges can be many and varied, but will typically include things like:

• Bid / offer spread:
  For any positive cashflows (usually premiums), the price of purchasing units offered to the investor is typically higher than the price at which units can be sold.
• AMC:
  Most investments will include some form of annual management fee.
• Advice charges:
  For investors who have received advice, either at the start of their investment or on an ongoing basis, there is usually an advice charge levied.
• Transaction costs:
  As transactions are made within a fund, there is often some delay between a deal being agreed and completed. This delay may lead to a change in price, which will affect the value of the fund (either positively or negatively).

Under MiFID II, costs and charges should be listed as one of three categories:

1. Product costs, which relate to costs which occur within the fund itself.
2. Service costs, which are any other costs charged by the management company.
3. Third-party charges, which are charges applied but paid to some other organisation.

Within the three categories listed above, costs and charges should further be categorised according to when they occur: one-off charges and ongoing charges are listed separately. Transaction costs, which are costs occurring due to transactions taking place within the fund itself, are also a separate category, as are ancillary costs and incidental costs.

The disclosure of the costs and charges on investments under MiFID II can be a complex issue, for the following reasons:

1. Specific charges do not always fit into only one group. On the project in question, the bid / offer spread was split between service costs and product costs.
2. Some charges will change their grouping based on several factors. For example, the bid / offer spread listed as service cost was listed as a third-party charge if and only if ongoing advice was received. If ongoing advice was not received, the charge still applied, but would be listed under service costs.
3. Some charges are not applicable at a unit-holder level. For example, transaction costs occur on transactions within the fund, not on investments made into the fund. The solution for this project was to identify the transaction costs across the fund for the annual period and calculate these as a percentage of the average fund value. This ratio was then applied to an average holdings value, which needed to be calculated for each unit-holder separately according to the unit movements of their investment

Along with the actual costs and charges, there is a requirement for MiFID II disclosure statements to show the return achieved by the investment both gross and net of any charges, and the cumulative effect of the charges.

Two main methods for doing so have been suggested:

1. A method proposed by TISA (Tax Incentivised Savings Association) – this is more rigorous but more complex.
2. A method proposed by PIMFA (Personal Investment Management & Financial Advice Association) – this is simpler and clearer but less accurate.

The issues outlined above show that at the heart of this area of MiFID II is an issue of complexity versus clarity.

Costs and charges on investments are typically complex; and communicating a complex situation clearly is not an easy matter.

It seems to me that there are four main approaches when required to do so:

1. To communicate only a small amount of information (that which can be communicated clearly) and to hide the rest. This is the approach which has usually been taken historically, and it has generally left investors in the dark. It is also the approach which the MiFID II rules are specifically designed to disallow, and as such, is no longer viable.
2. To communicate the situation as accurately as possible. This is obviously appealing, especially to those of us with an innate mathematical desire for precision. However, it will be much more expensive, as the complex charging situation will take a significant amount of time and money to model.
3. To communicate the situation as clearly as possible by making simplifications to the process. This has the benefit of being more understandable from the investor’s perspective. However, it will lead to a loss of accuracy and therefore will probably not be a true reflection of charges which have been levied.
4. To find some balance between communicating the situation accurately and clearly. This the most preferable approach in my opinion. MiFID II demands that unit-holders receive accurate and clear communications about the costs and charges which have been applied to their investments, and it is up to management companies to ensure that they find this balance.

In fact, MiFID II is just another example of the constant need for actuaries to know how to walk the line between communicating clearly and accurately. It may be hard for mathematicians to hear, but being right is often not enough; indeed, precision is sometimes only as important as clarity.

Chris Nash

October 2018