A regulatory butterfly effect threatens UK investment companies
An uneven playing field is preventing these funds from putting money into the productive economy
We have all heard of the butterfly effect — where small things have non-linear impacts on a complex system. That is happening right now in the UK market for closed-end investment funds, also known as investment companies.
Should we care that the market for investment companies, which at the end of July had 377 companies and £267bn of assets, has in effect been closed by a regulatory desire for artificial tidiness? Many investors and investees are fuming that they are now blocked from investing in the productive economy. The question for the UK Treasury and the regulator, the Financial Conduct Authority, is: why haven’t you stopped the butterfly from flapping its wings?
The first stirrings of this effect were discernible in the 2014 EU directive on packaged retail and insurance-based investment products (PRIIPS), which included a requirement for retail investors in funds of funds to be given a single figure “aggregate” of the charges that would be taken from their investment. I was chair of the European parliament’s economic and monetary affairs committee at the time.
It was pointed out late in proceedings that UK investment companies were treated as funds (regulated in Britain as collective investments) and best exempted from the directive. This didn’t happen, but for a long time it didn’t matter because that part of the PRIIPS directive was not activated. While I was in the chair, attempts to replicate the troublesome language in the EU’s Undertakings for the Collective Investment in Transferable Securities (Ucits) were beaten off.
Enter Brexit and the FCA’s desire to harmonise the different investment regimes and Investment Association guidance on cost disclosure. At this point, we find the butterfly effect being extended into Ucits and the Markets in Financial Instruments Directive (Mifid). Investment companies became subject to a “synthetic cost” calculation under which their corporate costs were added to the fund managers ongoing charges — even though they had already been taken into account in the share price. Shares in ordinary trading companies with identical business models can be held in funds without any synthetic cost being included. This makes investment companies look expensive to hold, as if the costs have to be taken off again from the share price, which is misleading.
The other factor that has come into play, also as a result of historical excess charges, is the prevalence of cost caps. The inclusion of investment company synthetic charges causes these to be breached. And this has forced money managers to dump investment companies, despite their professional judgment about their value to their clients.
As a consequence, there have been no significant initial public offerings of investment companies since the guidance started in January 2022 and follow-on funding has dried up. And, though it originated in the PRIIPS directive, this is a distinctly British issue due to the unique way our investment companies are regulated. Increasingly, large investment companies with internal management are shunning the IA’s guidance — after all, it is not compulsory. Meanwhile, those companies with external authorised corporate directors are, by and large, being forced to comply.
So what remains of the playing field is uneven. Unfortunately the hardest-hit sectors are productive and vital parts of the economy for which it is hard to raise funds or trade in other ways. Examples include solar, wind and battery power in the clean energy sector, real estate and private equity.
What, then, should be done? My view is the same as the one that the US takes with yield companies — they are companies and should be treated as such when it comes to corporate costs, just like the rest of the world. No one objects to transparency on fees — and they are a major focus for investment company non-executive directors. But there is no need for this confusion. We need to go back to the future before it’s too late.