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Defining and understanding different activities performed under a discretionary investment mandate

Posted on 19 July 2018   

The FSCA has published a discussion document on investment related matters in the context of the Retail Distribution Review and invites stakeholders to provide input on possible regulatory measures by 17 August 2018. 


In this article we focus on the proposals regarding the definition and understanding of the different activities performed under a discretionary investment mandate.

The FSCA holds the view that the definition of “discretionary FSP” is very broad and does not always distinguish between the different forms or types of services offered by these types of FSPs. For instance, one Category II (discretionary) FSP may offer a highly skilled investment management service while another FSP, holding the same licence, may offer a far simpler service yet charge the same fee. This inconsistency in fee or charge doesn’t align with the RDR activity-based approach which works on the principle that the fee paid must be in line with the service received.

The FSCA is now trying to address this inconsistency and, in a sense, to level the playing fields so that investment managers offering the same type of service are held to the same standards. They are proposing that, depending on the activities performed, the different types of Category II activities are placed into 4 broad categories, which will then be used to set licence criteria, fit and proper standards, etc. We discuss the 4 broad categories below.

  1. “Traditional” Investment Management

These investment managers typically construct portfolios by analysing and selecting underlying instruments. They are either appointed by a CIS management company to manage assets in one or more of its CIS portfolios, usually without interacting directly with the particular CIS investors (end-clients), or they manage a portfolio of assets for a specific investor on a segregated basis, often pension funds, corporates or high net worth individuals.

The FSCA wants to define the typical activities and combinations of activities which will accurately describe investment management (Table 1). They then want to use this as the benchmark against which any activity performed by a discretionary FSP can be tested and this will be the deciding factor as to whether an FSP falls into the definition of investment management or not. If the FSP meets the definition of a “traditional” investment manager, then the FSCA’s question is whether they need to meet a more demanding set of requirements than they currently need to meet under a Category II (and where applicable Category IIA) licence. If the decision is that a more stringent set of requirements must be met, then these types of investment managers will have to jump through a ‘new set of hoops’ in order to meet a higher set of requirements.

  1. Third-party co-branded Investment Management (‘white label’ arrangements)

This activity is similar to that performed by traditional investment managers, described above.  The difference is that here the portfolios are co-branded in that they carry the brand or name of the CIS manager and the third-party investment manager. In most, if not all, instances there is a Category I FSP linked to this Category II investment manager and the white-labelled portfolios are usually marketed and distributed by the third-party investment manager to investors/clients through its Category I financial advisors. Sometimes the third-party investment manager is also a Category I advisor. Therefore, in many of these models the third-party investment manager “owns” the distribution channel, although the CIS management companies have varying degrees of involvement in supporting that distribution channel.

The FSCA’s current thinking is that this activity is likely to meet the definition of “investment management” which will possibly include the activities set out in Table 1. This will mean FSPs performing these types of activities will also be required to meet whatever licence category criteria are set for “investment management”.

  1. Model Portfolio Management

This type of Category II activity involves selecting and designing customised or “model” portfolio solutions, most often made up of a selection of CIS portfolios. Where the model portfolio includes CIS portfolios offered by a number of different providers, the model portfolio provider is usually referred to as a “multi-manager”. Similar to third-party co-branding investment managers (point 2 above), these providers also market and distribute their model portfolios to investors through Category I advisors, that could be part of their own Category I licence, financial advisors in their company group or even through unrelated distribution channels.

If these activities are tested against the definition of “investment management”, then the FSCA’s view is that whether they meet the definition or not will depend on the specific type of services that they offer. In this latest paper they say it may therefore, be necessary to create a different licence category for Category II entities, that will not meet the new “investment management” definition.  For now, the FSCA is referring to this designation as a “model portfolio provider”, which only includes model portfolios made up of pooled assets, and they have identified possible activities (Table 2) which could be used to define a “model portfolio provider”.

If a new category for “model portfolio providers” is created, then a set of fit and proper standards will also have to be determined, both in terms of operational and competence requirements. And, it will also have to be decided whether these standards should be less severe than the requirements to be proposed for “investment management”. Consideration is being given to appropriate “line of business” training as well as an obligation for model portfolio managers to provide prescribed minimum disclosure documents in respect of their model portfolios, similar to those required in respect of CIS portfolios.

There is uncertainty at this stage, as to how to deal with or how to categorise a model portfolio manager of a portfolio comprising both CIS portfolios and non-pooled investments such as securities.  It is possible that their activities might fall outside the more limited scope of a model portfolio provider and require them to be licensed as an investment manager since they will be performing actual asset selection.

  1. Mandates held mainly for convenience

This category relates to those Category II FSPs who perform no or very little actual portfolio construction, design or selection. The main reason they obtain a discretionary mandate from customers is to avoid the need to obtain new written instructions from the customers every time portfolio switches are made, typically to rebalance the portfolio to align with the customer’s previously selected asset allocation.

At this stage, the FSCA’s stance is that by clearly defining activities required for “investment management” and/or “model portfolio management”, these “convenience” mandates will not meet the licence criteria and they will either fall away or be separately defined and categorised. If these types of mandates remain, and the FSCA currently believes there is a case for this, then there are likely to be some significant changes for these Category II FSPs, which could be as follows:

  • These FSPs are not regarded as exercising investment discretion, but rather as holding a more limited authority to perform specified services under a written “standing authorisation” from a customer so that the FSP does not have to obtain a separate written instruction every time.
  • Transactions will be limited to rebalancing a client’s portfolio in line with what the client originally agreed.
  • They may not describe themselves as investment managers or as model portfolio providers.
  • Any type of investment management fee or other payment for ‘discretionary’ services over and above an advice fee agreed to by the client will be prohibited. The rationale is that these mandates are purely ancillary to the investment advice provided and have mainly been put in place to ensure that the client’s portfolio remains in line with the advice originally given. Category II FSPs that fall into this category could be significantly impacted by this proposal if a portion of their income is, essentially, switched off.
  • The same fit and proper standards required for advice in relation to the types of investment products concerned will have to be met.

Conclusion

Our discussion above has been limited to the definition and categorisation of the different types of activities which discretionary FSPs perform. There are some significant changes on the horizon for those FSPs that fall into the “mandate for convenience” category, with some possibly affecting income. However, these proposals are in their preliminary stage and until the fit and proper and other licencing or operational standards have been set for each type of licence category, we don’t know the full impact.

In our next special edition, we will take a closer look at “categorising investment advisers within an RDR framework” and in our third and last edition, we will consider the impact on “remuneration and charging structures”.

The FSCA has invited comment and input to the proposals and measures put forward in the discussion document and Masthead will carefully consider the impact of these proposals on its members and we welcome your comments and views which will be consolidated into the feedback to the Conduct Authority.

Click here to read the full Discussion Document

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