In collaboration with national competent authorities across Europe, last November 2024 ESMA quietly kicked off an exercise focused on the costs associated with investments in UCITS and AIFs.

Designed as a two-stage data collection process, the exercise is testament to the progress European authorities have made over the recent past in piercing the veil of a sector traditionally opaque on its pricing data. On the one hand, product manufacturers are being asked to provide detailed information on the various costs charged for managing investment funds. Distributors, on the other, will report on fees that investors pay directly to them.

Part of a mandate for a broader review of the UCITS and AIFMD directives, the initiative – which likely went unnoticed – is a natural progression of the work initiated by European authorities on value for money. It also marks the beginning of a period of sharper focus on the economics of UCITS European distribution.

The European Take on Value for Money

With European authorities grappling for years with lacklustre engagement of retail investors in their capital markets, introducing a concept of value for money became a necessity. As part of a recent package of legislative measures, issued in a bid to increase trust of European retail investors in their capital markets, the assessment of value for money will soon become a reality also for European investment funds.

Where the concept is not at all new and existed already both in the US and in the UK, the European take on value for money is unique for its adoption of so-called category benchmarks. Built using a data driven approach, benchmarks aim to highlight outliers in the market and help competent authorities to identify investment products that so pose an increased risk of poor value for money relative to a set category.

As conceived, benchmarks are not meant to serve as price regulation mechanisms, standardise investment products or even stifle innovation. They are essentially a tool for authorities to supervise effectively the related value-for-money process. The main assumption remains that investment products with a similar risk profile and performance should cost by and large the same. However, diverging from a peer group should warrant a further scrutiny to ensure that any such investment product still offers value for money. Manufacturers and distributors must demonstrate value for money based on objective factors, even if their products are not on par with the average of the category of their specific product.

Setting aside the issue of potentially using value for money rules to regulate price of investment products, the new rules do not come free of criticism, expressed by European supervisory agencies themselves. In a letter to the European Commission, ESMA and EIOPA sustained that European benchmarks could add objectivity to the pricing process of investment products. Yet, unnecessary complexities of the entire value for money assessment, with the introduction of both national benchmarks as well as company’s peer groups, might jeopardise the success of the endeavour. In one with a lack of clearly identified powers of supervisory authorities to deal with outliers.

The entire value for money proposition, already a guarantee of increased focus also on the economics of UCITS European distribution, is being reinforced with the introduction of a notion of undue costs applicable both to UCITS and AIFs. This new concept should strengthen related enforcement actions by supervisory authorities.

Defining Undue Costs by Contrast

The proposal for a notion of undue costs under the UCITS and AIFMD directives came after two separate consecutive initiatives from ESMA. Immediately after costs and performance of retail investment products were identified in 2020 as strategic supervisory priorities within the European Union.

First a supervisory briefing was issued in 2020 to offer guidance on costs supervision for UCITS and AIFs, by addressing inconsistencies in the interpretation and enforcement of related provisions. Then a Common Supervisory Action came in 2021. Launched in collaboration with national competent authorities across Europe, the exercise focused on making sure that fund managers complied with the requirement not to charge investors undue costs. The Common Supervisory Action highlighted the need for a legislative definition of undue costs. To promote consistency and, most importantly, provide a stronger legal foundation for enforcement actions.

The notion of undue costs under the European legislation is introduced by means of defining the perimeter for due costs first, to identify undue costs by contrast. Under the proposal to amend the UCITS and AIFMD directives, due costs are subject to three sets of conditions. They must be in line with disclosures in the fund offering documentation, including retail disclosures. They must be necessary for UCITS to operate in line with their investment strategies and objectives or to fulfil regulatory requirements. Lastly, they must be borne by investors in a way that ensures their fair treatment.

As clarified by ESMA in an opinion on undue costs of UCITS, there is no need to reinvent the wheel to define the perimeter of cost eligibility. Within the vast repertoire of European regulation on financial services, PRIIPs regulation offers a fair guideline to help with assessing cost eligibility. However, the assessment of eligibility will not be as simple as cross-checking the list contained under PRIIPs regulation. Based on the nuisances of the specific investment policy or strategy of a fund, supervisory authorities should have room to deem as due also costs otherwise not listed under the PRIIPs regulation. At the same time, there will never be a shortage of instances where certain costs – per se eligible – become or should be deemed undue because of their quantum.

The Missed Opportunity of the Cross Border Distribution Directive

The forthcoming value for money rules will have different implications on the economics of UCITS European distribution depending on the type of fund managers. The most established fund houses are acquainted already with the myopic focus on price that characterises investors’ appetite in certain European and non-European markets. Their success lies in having embraced value for money already. Even before it became a requirement of the law. Adjustment will be necessary on the part of new entrants to European markets. With the difference that under the new rules, funds run inefficiently and that offer no value to investors will not only face unfavourable markets, but likely will not allowed to be marketed at all due to the new rules.

Common to managers at both sides of the cost spectrum is the quest to find new avenues to make their UCITS operations more cost effective. Overlooked so far by many, the Cross Border Distribution Directive offered an opportunity to reduce the costs involved in UCITS European Distribution.

The new version of article 92 UCITS directive, introduced by the Cross Border Distribution Directive, aims at fostering the overall cost efficiency of UCITS European distribution. More relevant for UCITS managers with either pan-European ambitions or established operations already, the opportunity should indeed appeal to all types of UCITS managers. That is to reduce the costs attracted by appointing brick-and-mortar paying agents in the host member states where UCITS are registered for marketing. Where the upside of cost saving is more immediate for smaller managers, bigger fund houses so far are the ones to have implemented the new rules in their UCITS European distribution operations.

Except for certain southern European markets, where nuisances of local tax regime and distribution dynamics make the digitalisation of the facilities agent under article 92 UCITS directive not possible, the rest of the EU 27 is ripe for making available digital facilities under the new regime. Where it is no longer required to appoint a brick-and-mortar facilities agent to comply with UCITS directive, related costs, where incurred, might also be deemed undue under the forthcoming undue costs definition.

Enhanced Requirements for UCITS Marketing Notifications

The Cross Border Distribution Directive does not offer only opportunities to make UCITS European distribution more cost efficient. Compliance with new requirements introduced under article 93 UCITS directive is poised to increase the ongoing charge figure of UCITS.

That is because of a small change in the formalities imposed on UCITS to notify authorities of amendments to the information provided at the time of obtaining initial marketing authorisations. These amendments – including changes in marketing arrangements – will have now to be notified not only to the authorities of the host member state concerned for marketing purposes, but also to the ones of the home state of the UCITS. Compliance with the new version of article 93 UCITS directive comes with an additional administrative burden. Filling in an amended notification letter each time any such change is notified. The additional task will result inevitably in a new stream of charges for UCITS, unless smart digital solutions can be deployed to comply in a more cost-efficient manner with these heightened compliance requirements.

Conclusions – The Economics of UCITS European Distribution

The combined rules on value for money and undue costs will inevitably push UCITS fund managers to optimize their operations. Embracing digital solutions for compliance with the new requirements under UCITS directive will help striking a better balance between meeting regulatory expectations while maintaining a strong market presence in Europe.