Suitability and the advice process under Mifid II

This was enhanced when the financial crisis hit in 2007-2008, putting the need for greater transparency and protections in place. 

As the Financial Conduct Authority (FCA), the body responsible for implementing Mifid II in the UK, has claimed, it will “strengthen investor protection”.

“In the words of the FCA”, says Richard Romer-Lee, managing director of Square Mile Investment Consulting and Research, “Mifid II aims to strengthen investor protection, reduce the risk of disorderly markets, reduce systemic risks and increase the efficiency of financial markets, and reduce unnecessary costs.”

According to Linda Gibson, director of regulatory change and compliance risk for BNY Mellon’s Pershing, the new suitability requirements under Mifid II revolve “around investor protection and ensuring that investment firms act in their clients’ best interests”.

This is a big question for advisers. According to David Ogden, compliance manager for Seven Investment Management, one of the most common questions being asked by advisers on Mifid II is: 'Suitability reviews must be conducted annually. How will that work in practice?'

But in essence, says Susann Altkemper, counsel for City law firm CMS, Mifid II does not “fundamentally” change the requirements relating to suitability.

Advisers should start looking at their client base, the target market of the fund and who it is being aimed at. Jackie Beard

What it does do, however is “impose a new obligation on investment advisers to provide suitability reports to retail clients before any transaction is concluded.

Ms Altkemper comments: “In practice, this might be difficult to achieve, and unless advisers can rely on a narrowly drafted exception, they will need to adjust their processes or consider changes to business models altogether.”

She points out that suitability reports are required where the advice does not lead to a transaction, or where the advice is not to buy or sell a financial instrument.

The implication is that where there is no trade or transaction, advisers may have not kept detailed documentation on such advice beforehand. This all changes under Mifid II.

Those firms already keeping extensive and detailed file notes will “not find it overly burdensome to produce Mifid II-compliant suitability reports,” says Ms Altkemper.

However, she warns: “Other firms will need to assess carefully whether they obtain all client information necessary to deliver Mifid-II suitability reports, and they may need to increase existing resources to undertake suitability assessments and record output in a fully compliant manner.”

Definitions

The incoming second wave of the directive will also clear up the definition of what is considered investment advice, and what sort of instruments will fall under that definition, as well as capturing in its scope advisory services operating through electronic or automated systems. The full range of official European Union documents relating to Mifid II can be found online. 

This means suitability needs to be at the heart of the entire investment process, from fund creation through to distribution, whether through a discretionary fund manager, investment adviser or electronic broker system, and these suitability checks must be conducted regularly.

According to Jennine Watts, regulatory solutions manager at SEI Wealth Platform, the impacts of suitability are “wider reaching”, meaning advisers must show not only whether the product was suitable, but also whether there were better alternatives. 

For example, advisers must be able to show a cost/benefit analysis that demonstrates whether another suitable product had lower entry or exit costs.

She says issues of suitability under Mifid II will also consider the increasing use of robo advice.

Ms Watts comments: “Inevitably, what all this means with regard to suitability of advised and portfolio management services is that the use of electronic processes does not diminish the firm’s responsibilities in any way.”

Moreover, advisers cannot just state to the regulator that they met the definitions of suitability, they “have to state how suitability is met”, Ms Watts adds. 

Application and scope

Who does the directive apply to? According to the FCA: 

•    interdealer brokers.
•    firms engaging in algorithmic and high-frequency trading.
•    trading venues including regulated markets, multilateral trading facilities, and prospective organised trading facilities.
•    prospective data reporting service providers.
•    investment managers.
•    stockbrokers.
•    investment advisers.
•    corporate finance firms and venture capital firms.

Jackie Beard, director of manager research services for Morningstar in EMEA, comments: “Advisers should start looking at their client base, the target market of the fund and who it is being aimed at. 

“I know it’s never directly comparable; for example, an institutional fund could be made available to retail investors and benefit certain retail investors. 

“However, the target audience of a fund is something that, under Mifid II, advisers should be considering and thankfully they will have information they did not have before.”

Yet Connor Sloman, head of products and client solutions for Morningstar’s EMEA division, points out: “Mifid II is not black and white for advisers when it comes to using target market information in their investment recommendations.

“There may be circumstances where it is appropriate for a product to be sold to an investor in a different target market, but advisers must justify their individual security decisions as enhancing the suitability or diversification of the investor’s portfolio.”

Regularity

Ms Gibson adds that regularity of suitability checking will be required from January onwards: assessing suitability is not a one-off exercise to be conducted at the point of recommendation only.

She explains: “The issues of due diligence and suitable advice are addressed through requirements of periodic suitability assessments and reports, which should also include advice on switching investments.”

Ms Beard agrees such checks should be made annually or semi-annually, and documented as part of regular reviews. 

She points to chapter three of the Delegated Directive – the Commission Delegated Directive (EU) 2017/593 – on investor protections. 

“This requires investment firms of member states to check whether their own funds are still fit for purpose for today’s investors and that they offer good value,” Ms Beard adds.

Any advisers running in-house investment portfolios will fall within the scope of this directive; even if advisers do not run their own funds, it is best practice to check that a third-party manager’s funds are meeting those requirements.

Morningstar’s list of what you should check for: 

• Does the product function as intended?
• Is it still fit for purpose?
• Is it offering good value?
• Do the managers/advisers review products when they become aware of an event that could materially affect the potential risk to investors?

Ms Watts states there is a “heightened obligation” on financial advisers to understand their clients’ objectives and circumstances under suitability. 

To help do this, she advocates “replaying those back to the client before (or immediately after) investment, and thereafter periodically".

“This is the essence of knowing your client and ensuring you are acting in the best interest for the duration of your relationship with them.”

Onus on distributors

Investment advisers, wealth managers, discretionary fund managers and those distributing funds have specific duties for due diligence and record-keeping under Mifid II, as laid out in chapter 3 article 10 of the Delegated Directive.

As Ms Gibson says: “Mifid II’s additional suitability requirements provide an opportunity to improve client servicing and advisory services.”

For example, wealth advisers must consider whether the product manufacturer has paid enough attention to the following three areas before recommending a fund:

1) Product governance: The directive states: “Member States shall require investment firms to have in place adequate product governance arrangements to ensure the products and services they intend to offer or recommend are compatible with the needs, characteristics, and objectives of an identified target market and that the intended distribution strategy is consistent with the identified target market. 

2) Client circumstances: “Investment firms shall appropriately identify and assess the circumstances and needs of the clients they intend to focus on, so as to ensure that clients' interests are not compromised as a result of commercial or funding pressures. As part of this process, firms shall identify any groups of clients for whose needs, characteristics and objectives the product or service is not compatible. 

3) Product and audience knowledge: “Member States shall ensure that investment firms obtain from manufactures that are subject to Directive 2014/65/EU information to gain the necessary understanding and knowledge of the products they intend to recommend or sell in order to ensure that these products will be distributed in accordance with the needs, characteristics and objectives of the identified target market."

Greater focus 

For most advisers, according to Richard Janes, spokesman for Brewin Dolphin, the daily routine of assessing suitability is already “well defined in the UK, and Mifid II does not fundamentally disturb this”.

As Barry Neilson, business development director for Nucleus comments, “a lot of the new rules on suitability under Mifid II basically formalise guidance that already exists”.

However, Mr Janes says although the daily practice for advisers will not change significantly, Mifid II does cause subtle shifts in the nuance of assessing suitability.

He explains: “The increase in obligations are in relation to those advisory businesses where the obligation for suitability reports for all recommendations are now required.”

For these firms, this means a far greater focus on product, target market, cost and appropriateness. It also means providers need to give more information to advisers to make their recommendations in the first place.

If an adviser is placing a transaction on behalf of a client without giving advice, then the adviser will be asked to confirm that an appropriateness check has been carried out. David Ogden

With the proliferation of funds across Europe from which a whole-of-market financial adviser must choose, it becomes imperative under Mifid II to have proper data on which to compare funds. 

Assessing suitability and making recommendations rely on the quality and clarity of the information and data provided by fund managers. Under Mifid II, fund management firms will be required to show proof of how funds are being assessed by the distributors. 

Any flaws that are evidenced regularly will draw regulatory scrutiny towards the fund manager if the manager ignores those reviews. 

But even so, different countries will be implementing Mifid II in a slightly different way. For example, the UK’s Financial Conduct Authority has made it clear it will gold-plate certain aspects of Mifid II.

Complex or not? 

It might be hard for advisers to make sense of the various data points offered by the multitude of funds, let alone to do a proper comparative study of these to help make investment recommendations that are suitable and appropriate for each client.

"Another question we have had is 'How will you identify complex and non-complex products?", says Mr Ogden. For advisers working with Seven Investment Management, Mr Ogden says the firm will be obtaining a feed of information from an external supplier, which will show complex products.

Generally, he says: "If an adviser is placing a transaction on behalf of a client without giving advice, then the adviser will be asked to confirm that an appropriateness check has been carried out. 

"Appropriateness checks are only required for instructions executed on a non-advised basis. For advised trades into complex products, it is assumed the adviser will have undertaken client suitability and hence providing a personal recommendation, and so no appropriateness check is required."

This is where qualitative and quantitative evaluation can be helpful; for example, Morningstar has developed a range of due diligence score cards to help review funds through the same lens and provide a measure of consistency.

But it also means advisers must themselves be consistent and compliant when they make a fund recommendation, and ensure that client information is kept up to date to ensure suitability at all levels: product and personal recommendation.

It comes back to a point made by CMS’s Ms Altkemper, who adds: “Changes in firm’s processes and procedures will be needed to ensure that client information is reliable and up to date, so that periodic suitability reports can be generated for clients who receive ongoing advice.”

Red flags

The greater information available to advisers to use in assessing a fund’s suitability for their clients will also mean there is a subtle shift in focus from product sales to investor suitability.

This could eventually lead to a contraction in the investment market that works in the adviser’s and client’s interests.

For Ms Beard, this means certain long-standing but unnecessary share classes – particularly legacy ones where poor performance and high fees have a doubly detrimental effect on the investor – may end up being closed.

She says the greater openness means advisers will have a better audit trail to see whether the funds have been delivering value for money and doing what they have set out to do. 

“If advisers monitor the funds and a flag is raised about a fund consistently showing up as poor quality, advisers have the right to make a noise about it. 

“There are too many funds sitting around that serve no purpose.”

Fitz Partners research into ‘twin share classes’ – where the share classes of a particular fund are identical in every aspect but the management fee and performance fee – has found some funds could have an average discrepancy of up to 26 basis points when it comes to the management fee.

The research suggests that where a performance fee is added onto the management fee, the provider on average puts a discount on this share class, meaning products whose ongoing charges include management and performance fees could be cheaper by 19 basis points than funds which only have a management fee.

Such discrepancies are confusing and illogical for investors – and Mifid II should go some way to cleaning up such legacy pricing structures.

Ms Beard reiterates this point in her research note, Mifid II: It's Not Just an Equity Research Issue: Understanding the Fund Reporting Requirements, in which she comments: “Some funds have less relevance in today’s investing world. Notwithstanding the fact costs would be involved in fund closures, there is complacency among asset managers. 

“Investor inertia – or lack of awareness – also plays a role.”

simoney.kyriakou@ft.com