Mary Leung, Head - Standards and Advocacy, Asia Pacific at CFA Institute, talked about the key regulatory reforms undertaken in markets like US, UK, Europe and Australia and its impact on the industry at the Morningstar Investment Conference 2019 in Mumbai.
Intermediaries play a very important role. They liaison with manufacturers and investors. They bring assets and clients. Manufacturers give them training and pay them to sell their products.
Commissions seem to be the most prevailing form of incentivizing a sales force and it works mostly, especially if everyone's making money. But increasingly, people are focusing on investor outcomes, especially after the global financial crisis.
There have been questions about suitability of products for investors. Are they being sold because they are good for the customer, or are they being sold because they generate fat fee? And from the intermediary’s perspective - are they selling something because they have a special relationship with manufacturers?
How do you avoid the conflict of interest?
The other complexity is that investors don’t know what they're paying and to whom. We have upfront, trail, entry and exit loads. For investors, it can be confusing.
Early this year, we started projects to look at sales inducements in Asia Pacific, and how the incentivization of intermediaries impacts investor outcome. We took a deep dive in four Asia Pacific markets - Australia, Hong Kong, India and Singapore. We did broad literature review, and we interviewed a large number of stakeholders in the industry, including fund management companies, advisers, distributors, banks, investors and regulators.
There have been a lot of policy responses in the last decade in order to fix these issues. And regulators have a tough job in doing so because they have other objectives beyond investor protection. Even though not all regulators have the same mandates, their concerns are broadly similar. Investor protection is one of them. But they also want healthy competition in the market which would bring down the fee charged to investors.
One of the tools is fees and commissions. Whatever tools the regulator uses, there must be transparency and disclosure. It's not just about disclosure. It's about useful information that's clear, concise and simple that allows investors to make informed decisions.
Let’s look at some of the global regulatory trends in advisory.
United States
In Canada and U.S., both fees and commissions are allowed. In U.S., mutual funds are sold through brokers, dealers and Registered Investment Advisers (RIAs). They have different standards of care for clients. RIAs work towards a fiduciary standard, the best interest standard, whereas broker dealers only have to observe a suitability standard.
But they have similar names. They interact with the same clients, and they can call themselves advisers and that creates huge confusion in investors’ minds.
Earlier this year, the SEC in the U.S. approved Regulation Best Interest. There were huge hopes that it would improve investor protection. But it's the same old brokers and advisers who continue to be regulated separately, even though it's called best interest. They don't actually define what best interest is, and only require that brokers do not put their own interests ahead of clients. That's a huge missed opportunity.
United Kingdom
In the U.K. and Europe, in the U.K. in particular, they had seen huge mis-selling scandals before the global financial crisis. And the regulator introduced reforms called the Retail Distribution Review (RDR). They became the first country to ban commissions entirely in 2012.
RDR also raised minimum qualifications for advisers. There were concerns that this will create advise gap. In the commission model, retail clients were subsidized by bigger clients. But now, people thought retail clients would not be able to afford advice so there would be an advice gap. And because of the rise in professional qualifications, there were fears that a lot of advisers may exit the market.
Fortunately, a couple years after the implementation of this change, there was some attrition among advisers, but it was not drastic. So, the advice gap did not materialize. But the benefit was that investors were beginning to embrace cheaper products. The regulator is planning another post implementation review, which will be available in 2020.
Europe
In the European region, Markets In Financial Instruments Directive II (MiFID) became effective in 2018. This regulation established minimum standards for fund distribution. U.K. and Holland banned commissions entirely. But most other countries in EU actually didn’t ban commissions entirely. They enacted a partial ban. It only really applies to independent advisers who can't accept payments from anyone other than their clients. And if they do, they will have to rebate it to clients.
If you are not an independent adviser, you can still receive commissions in the EU, but it has to be in return for a value-added service. So, it may be advice, it may be execution, it may be some other service. You can't just take the fee for indefinitely for having sold the product at one time.
Australia
Australia is a developed market, it's wealthy. It hasn't had a recession in 30 years. It also has a banking oligopoly. It has four large banks that dominate. Australia has the fourth largest pension fund assets (superannuation assets) in the world. The pension fund assets are 131% of GDP. That means it has a huge asset management industry locally. And people need to also get advised to make sure that their pension assets are invested properly.
In 2012, Australia enacted a package of reforms called the Future of Financial Advice (FOFA). The objectives of FOFA were to improve trust and confidence and ensure availability, accessibility and affordability of quality advice. They introduced a best interest duty so that you have to take your clients best interest when giving advice. Also, they banned commissions – upfront and trail. They only get a fee.
They also introduced opt in obligation for fee renewal and mandated annual fee disclosures.
FOFA looked fantastic on paper. Did it work?
These new regulations would have upended the industry. To give the industry time to transition, the government toned down some of the rules. For example, they allowed grandfathering of commissions on products that were sold before FOFA came in. So advisers could still earn trail commissions. They also put in a safe harbor for the best interest duty.
Despite FOFA, there was still selling issues in the industry. And at the end of 2017, the government called for an independent inquiry which was called the Royal Commission into misconduct in the banking, superannuation and financial services industry. They ran the process in 2018. They conducted seven rounds of public hearings, called over 100 witnesses, some of them were senior management and CEOs of large banks and wealth managers.
What they discovered was quite staggering. Not only did they uncover misconduct by major banks and financial advisers, they uncovered the fact that actually a lot of banks were lying to the regulators. Revenue generation was prioritized over client’s best interest and fees were deducted even when no service was provided.
In 2019, the final report came out. The commissioner called for 76 recommendations on culture, governance, remuneration and regulation. They suggested that we should remove the conflict of interest, improve quality of advice and stop grandfathering of commissions.
CFA Institute partnered with our societies in Australia and developed a response to the commission reports and we made recommendations along the lines of best interest and removing grandfathering of commissions. The lesson learned in Australia is that even when you have a commission free system it's not bullet proof. FOFA looked fantastic on paper, but many things needed to work together. You need systems to monitor, survey and enforce. If you don't enforce them, it's not good enough. The other lesson that we learned from Australia was that we need to watch out for the measures to help transition because they can be abused.
Some of the other issues that came out was that if you have a sales team that are too focused on making sales, that may lead to bad behavior. What we need is a remuneration system that encourages good behavior and deter bad behavior.
Hong Kong and Singapore
Hong Kong and Singapore are similar. They are developed markets. They have active retail participation, with small cities and high GDP per capita. They were also affected by the global financial crisis. Many people lost a lot of their money in muni bonds and accumulators, which led to tightening of regulation. And in both markets, the fund distribution channels were dominated by banks, about 70% of market share, and they charged people an upfront commission plus a trailer fee. Both markets, considered a ban on commission, but both rejected them citing investors' reluctance to pay.
Both markets placed emphasis on strengthening suitability requirements and the requirement to disclose. And in Hong Kong in particular, they had something called the manager in charge regime. They made senior managers personally accountable, and that meant a lot of lost sleep. And that had a huge impact on how senior managers supervise their salesforce.
But there are differences between the two markets as well. The one key difference is that in Singapore, there is a single unified regulator - The Monetary Authority of Singapore. This helps minimize regulatory arbitrage.
In Hong Kong, different entities are regulated by different regulators. So, if you are an insurance company you get regulated by the Insurance Authority. If you are a bank, you'll be regulated by the Hong Kong Monetary Authority, and so on.
Another key difference is on the definition of independent adviser. In Hong Kong, you can't be independent if you take payments from someone else other than your clients. In Singapore, if you take a little bit from someone else, that's fine.
The regulatory burden in these two markets were quite high. When you have a stringent compliance, it benefits large companies as they have the financial resources to invest in teams.
They have the financial resources to invest in systems that can automate these processes. Also, fund companies would like to deal with established players like bank or large distribution houses.
India
Indian asset management industry has seen a tremendous growth, reaching $362 billion or Rs 26 trillion recently. As the industry grew the regulator also increased its vigilance. SEBI’s focus was to ensure that growth is sustainable and not at the expense of investors.
What can be done in India?
End Regulatory Arbitrage
We need to bring level playing field for all financial products. Mutual funds are regulated by SEBI, but there are other similar products that may not be regulated by the same regulators and they may have different standards. Efforts to bring more products under one regulator is very important.
Investor Education
We need to educate investors to raise the standards on financial literacy. We need to be able to assess so the quality of services and products that are offered to investors will help raise the industry up.
Removing conflicted remuneration is not the solution
What does a healthy market look like? Every market is different. There's no one-size-fits-all solution. All good markets share these characteristics - sound protection, access to quality advice, high degree of professionalism and fee transparency. We should also be managing conflicts of interest. And instill a culture of accountability.
So how do we get there? Fees and commissions are the most obvious tool, but it's not obvious as to which one is better. Even if you change from a commission to a fee system, it may not answer all your questions if the enforcement is not there, if the culture is not there.
Everyone in the ecosystem has a role to play, whether you are a manufacturer, an intermediary, a regulator or investor. Raising professionalism and level of transparency and having clients' best interest in mind will go a long way in making your business weatherproof.
