How IFAs can access ETFs

Deborah Fuhr, global head of ETF research and implementation strategy at BlackRock, discusses the potential for greater uptake of ETFs by Independent Financial Advisers, in light of regulatory developments

Retail investors account for 40-50% of ETF investors in the US but only 10-15% in Europe. The use of ETFs is likely to increase significantly among Independent Financial Advisers (IFAs) in the UK based on regulatory proposals. These were originally outlined on 25 November 2008 in the Retail Distribution Review (RDR) feedback statement, by the UK’s Financial Services Authority (FSA).

In the US, fee-based advisers, paid by the consumer, have embraced the use of ETFs to a greater degree than commission-based advisers, who are paid by the product provider. In the UK the use of ETFs among IFAs is very limited as they are typically multi-tied and tied, and ETFs are not currently included in the tied or multi-tied product sets. 

The proposals outline changes the FSA plans to make for the retail investment market to establish a new level of consumer trust and confidence, by distinguishing between independent advice and sales advice to create better clarity for consumers.

Large online brokers and fund platforms in the US have been embracing ETFs as a competitive marketing tool in recent months. Charles Schwab has started to offer its own ETFs and commission-free trading while Fidelity has partnered with iShares to offer commission-free trading on 25 specific iShares. Based on the FSA’s review of platforms, these types of trends are also likely to develop in the UK and Europe.

It has become hard for participants in the financial markets to ignore a product category which broke through the one trillion dollar mark in assets under management for the first time at the end of 2009. Today there is a growing fan club, citing ETFs as one of the greatest financial innovations in the past two decades.

There is an expanding toolbox of ETFs listed on the London Stock Exchange providing investors with access to a range of exposures including European, North American, Asia Pacific and Global equities, Emerging Markets, fixed income, commodities and currencies. ETFs can be suitable investments for ISAs, PEPs and fund of funds/fund of ETFs.

ETFs in the UK: statistical update

• The UK ETF industry had 162 ETFs with 363 listings, assets of $49.8bn, from nine providers on one exchange at the end of Q1 2010.
• Year to date (YTD) assets have increased by 5.8%, compared to the 1.5% fall in the MSCI UK index in US dollar terms.
• There are 22 ETFs listed in the UK with assets greater than $1bn, 101 ETFs with assets greater than $100m, while 45 ETFs have assets less than $10m.
• YTD the number of ETFs increased by 14.1% with 20 new ETFs launched.
• YTD the average daily trading volume in US dollars decreased by 12.6% to $302.3m. Most ETF trades are not required to be reported in Europe, as ETFs are not covered by the European Union Directive on Markets in Financial Instruments (Mifid).
• The asset weighted average Total Expense Ratio (TER) for ETFs listed in the UK is 42 basis points.
• In the UK, the net sales of mutual funds amounted to $43.2bn in 2009, with assets reaching $729.1bn in 2,266 funds at the end of Q4 2009, according to data from the Investment Company Institute (ICI).
• Many UK based investors prefer ETFs with UK Distributor status for tax efficiency. In the UK there are over 150 ETFs with UK Distributor status.
• Additionally, there were 218 ETPs with 248 listings in the UK, assets of $15.6bn from six providers on one exchange.

UK Distributor Status (UKDS)

It is worth noting that none of the ETFs listed in the UK are also domiciled in the UK, which means they are all considered to be offshore funds from a UK tax perspective.

The offshore funds rules were originally enacted at a time, as now, when there was a substantial difference between the rates of income tax and capital gains tax, to prevent investors in offshore vehicles from converting income accumulated within the offshore vehicle into capital on the disposal of that interest. 

The offshore funds rules therefore provide that gains made on the disposal of an interest in an offshore fund are subject to income tax, rather than capital gains tax. The effect of this is to increase the tax payable on gains realised by the investor from 18% to 50%, substantially reducing their profit. The exception to this is for “distributor status funds”, those which distribute their income to investors on an annual basis, where the income is taxed annually and the gain made on disposal is subject to capital gains tax treatment.

Obtaining UK distributor status is an important consideration for any offshore fund seeking to attract UK investors, as tax will be a key issue for investors selecting an offshore fund. The UK offshore funds legislation treats gains from offshore funds as income, rather than capital for tax purposes. Gains are thus subject to income tax rates (top rate of 50%) without any capital gains tax relief. However, if the fund obtains UK distributor status, gains will be treated as capital gains which effectively will be subject to capital gains tax of 18%, and will be entitled to annual exemptions.

The existing UK Distributor Status (UKDS) regime for funds will be replaced by a new ‘Reporting Fund’ system. The new system began on 1 December 2009 (specifically fund accounting periods starting on or after 1 December 2009), but for existing funds there is a transitional period that stretches into 2011.

UK Retail Distribution Review (RDR)

On 26 March 2010, FSA published its feedback statement, Policy Statement 10/6, to its Consultation Paper of June 2009 (CP09/18), relating to proposals to improve the clarity with which adviser firms describe their services to consumers. The paper also proposes the introduction of an ‘adviser-charging’ system, to remove the potential commission-bias through the influence of product providers.

The Policy Statement contains final rules in relation to ‘adviser-charging’ and ‘service-labelling’ and FSA will proceed with the proposals set out in the consultation. Therefore, with effect from 1 January 2013, advisers will be prevented from receiving commissions paid by product providers. 

FSA notes that it wants adviser firms to have charging structures that are product neutral in that the charges reflect the services provided to the client, not the particular product provider or type of product. Product providers are no longer required to monitor ‘appropriate adviser-charging’ – with reference to so-called ‘decency limits’ –though there remains a requirement to obtain and validate instructions from the client if the charge is deducted, by the provider, from the client’s investment. 

This creates a significant challenge for providers, as due to a result of increasing disintermediation, in part because of the growth of platforms, the end-consumer will not be a direct client of the firm. 

FSA accepts that bespoke share classes to provide for a full range of possible adviser charges, when taken from funds, is impractical and recognises the value of cash accounts provided by platforms or other third-parties to collect adviser charges. This is a particularly important development for factory-gate priced products such as most ETFs. 

However, it is uncertain whether the current practice of rebating a proportion of the annual management charge, if this is used to fund the consumer cash account, will be acceptable; FSA states that it intends to consult further on whether any rebates should be prohibited. 

In addition, FSA will proceed with proposals for advisers to describe the advice provided as either independent or ‘restricted’. Firms offering independent advice will need to demonstrate their recommendations are based on a comprehensive and unbiased analysis of the market and that any products selected are made in the interests of clients. 

If a firm elects to limit its product range to certain investments or strategies, it will need to describe its services as ‘restricted’ and this must be clearly disclosed to the consumer. FSA notes it may be possible for certain advisers servicing specialist client groups to retain the independence ‘label’ even where certain products are excluded from the scope of their advice, although the firm would have to demonstrate the product or strategy was not appropriate for their clients. 

FSA observes this exception is unlikely to be of benefit to most firms since most retail investment products are likely to be appropriate for the vast majority of retail investors. Separately, FSA notes it was clear from responses received that it was not widely understood ETFs already fall within the current definition of packaged products. To avoid doubt, it is made clear any products which might achieve similar outcomes as more traditional retail investment products are potentially caught by the new rules.

UK Fund Platforms Review

In addition to the feedback statement noted above, FSA has also published the long-awaited discussion paper on the role of platforms in facilitating the delivery of the RDR objectives. 

In particular, the paper discusses how platforms should be remunerated in a post-RDR world. FSA has made clear that its ultimate objective is to separate or ‘unbundle’ product and platform charges to provide greater transparency to consumers. 

FSA expresses a clear preference for the ‘wrap’ model where either the consumer pays a wrap fee or product charges are rebated, although clearly the latter scenario will be subject to further consideration. 

The regulatory body goes on to say that it would be prepared to prevent all payments to platforms by product providers as it observes payments are often to secure ‘shelf-space’, have little relationship to the utility service provided by the platform and typically are used for purposes which do not directly benefit the consumer. This view draws strong parallels with the position under the Mifid Inducements regime. Although this is not FSA’s final view on the topic, it clearly calls into question the economics of how platforms will be paid post-RDR. 

There is no requirement for platforms to extend their service model to be able to trade listed instruments such as ETFs, but with the increasing adoption of ETFs by advisers, many platforms are already reviewing and building the functionality to provide wider securities access. Also, in response to calls from the industry, the FSA intends to make compulsory the transferability of investments from one platform to another. 

The FSA intends to formally consult on proposals to regulate platforms in the summer and expects to publish final rules by the end of this year, which does not give platforms a significant amount of time to implement the necessary changes to their business models. This will inevitably require significant input from product providers and the adviser community. 

Comments on the discussion paper have been invited up to and including 26 May and BlackRock, like many of our competitors, continue to work with the Investment Management Association and other industry practitioners to ensure that our views are fully represented in ongoing discussions with the FSA.