ESMA report on UCITS costs and fees: Key points

On 31 May 2022, ESMA published its Report on the Common Supervisory Action ("CSA") on costs and fees of UCITS that was carried out with national competent authorities ("NCAs") (including the CSSF) in 2021.

This report sets out ESMA's analysis and conclusions on the CSA and presents ESMA’s views on the various findings, including on the process of the setting and the reviewing of fees, the notion of undue costs, the issues stemming from related party transactions and EPM techniques, as well as the follow-up actions envisaged by NCAs and the main lessons learnt.

This report is therefore important not only for NCAs but also for the funds and their managers.

1. 1. Setting and review of the fees

• Structured and formalised pricing process: ESMA stresses the importance for all UCITS managers to have in place a structured and formalised pricing process, in line with the characteristics of the fund(s) and the recommendations of the supervisory briefing on the supervision of costs in UCITS and AIFs (dated 4 June 2020) ("Supervisory Briefing"), regardless of the characteristics of the management company, including the size of AuM.
• Internal control function: the senior management should have an active role in the pricing setting and the challenging of the output.
• In case of delegation: it is important that the UCITS ManCo performs sufficient controls and does not over-rely on the portfolio managers for the pricing of the fund, i.e. delegates sometimes exercise significant influence or even decide the level of costs.
• Sustainability of the costs: the analysis of the sustainability of the costs over time and the relative weight of fees on the investor's return is key when setting the pricing structure of the fund.

ESMA also states the application of the principle of proportionality cannot result in a situation where some smaller UCITS managers disapply these requirements altogether.

1. 2. Undue costs

In the course of the CSA, ESMA noted divergent market practices as to what industry reported as “due” or “undue” costs. ESMA therefore states that the notion of undue cost should be primarily assessed against what should be considered the best interest of the fund and its investors and recalls the importance to comply with the recommendations of the Supervisory Briefing.

1. 3. Related party transactions

In this respect, NCAs reported that UCITS managers covered in the CSA sample identified relevant conflicts of interest, in particular in cases of related-party transactions. However, ESMA noted that beyond general measures such as educating employees on the code of conduct, disclosing conflicts of interest in the fund prospectus, etc., NCAs did not report more specific or concrete measures implemented by relevant managers to ensure an effective mitigation of conflicts of interest in related-party transactions.

ESMA therefore draws NCAs’ attention to the potential risk for intragroup/related-party transactions to result in higher costs and/or costs higher than average for investors.

1. 4. Quantitative findings

In the course of the CSA, NCAs were asked to perform an assessment regarding the level of ongoing charges figure and detect potential outliers, i.e. funds charging fees higher than their peers.

Some NCAs reported that smaller entities constituted the largest part of the outliers identified. This was mainly due to the smaller amount of AuM and the higher impact of fixed costs.

NCAs are therefore invited to specifically address the topic of costs of smaller funds/managers, i.e. where the risk of investors being charged with undue costs appears to be higher due to the lack of a structured pricing process.

5. Efficient portfolio management (EPMs) techniques

ESMA notes that in some instances, there is a lack of policies and procedures on EPMs and lack of clear disclosures as required under the ESMA Guidelines on ETFs and other UCITS issues and that certain fee split arrangements (especially with securities lending agents within their own group) raise the risks of investors being overcharged.

ESMA therefore invites the relevant NCAs in those cases to consider taking stricter follow-up measures including enforcement actions, where appropriate.

1. 6. Follow-up actions envisaged by NCAs

The NCAs's general preference is to use escalated supervisory measures instead of taking stricter enforcement measures. However, ESMA invites the NCAs to also consider enforcement actions in the limited cases where a significant regulatory breach was identified, particularly bearing in mind that the area of costs and fees is a priority area (i.e. a Union Strategic Supervisory Priority (USSP)) and given its high investor protection relevance.

ESMA also stresses the importance of ensuring that investors are adequately compensated in all cases where they were charged with undue costs/fees or there were calculation errors that resulted in a financial detriment for investors.

7. ESMA views on the main lessons learnt from the CSA

ESMA encourages NCAs to control of the cost/fee structure of the fund at funds’ authorisation stage and to perform enhanced scrutiny on the topic of costs and fees as part of NCAs’ gatekeeping role with a view to addressing the important investor protection risks in this area in a more timely and effective manner.

ESMA encourages other NCAs to ensure that fees are lowered, and investors compensated in cases where undue costs were charged and/or costs were wrongly calculated.