There are several provisions in Mifid II, which kicked in earlier this month, which could warrant different chapters of a large book.
One of these, which will result in clients receiving more information about the performance of their portfolio, is the requirement to report before the end of a business day if a portfolio has dropped 10% or more, when compared against the valuation at the beginning of a quarterly reporting period.
The client must also be informed of any further 10% depreciation within the same period. Obviously, portfolio declines of 10% or more are not a welcome development for any wealth manager/client discussion.
To clear any lingering confusion, 10% drop reporting is not a maximum drawdown. This is because it is limited to a ‘peak to trough’ value of a portfolio within a quarterly reporting period, not its full historical valuation.
The question is, how often will action need to be taken?
What does the data say?
Against the backdrop of the historically low market volatility in the last few years, we have collected data from 1985 for the FTSE All Share index to gain sufficient data points. If we assume that reporting periods are based on calendar quarters, there are 129 periods involved and 10 instances with 10% or more on a total return basis (as to 29 December 2017).
If we include the total annual fees of running client portfolios (platform charges, adviser, transactions, DFM, etc) which may top 2% and translate to 50 basis points quarterly, then instances where portfolios record quarterly losses of 10% or more increase to 13, which is about 10% of the time.
Although it has been nearly seven years since the last 10% fall (Q3 2011, amid concerns surrounding Spain, Italy and the European sovereign debt crisis), not many would bet against market correction being potentially imminent.
The 10% rule, specifically the onus of responsibility over informing the client, has opened up the traditional battleground between DFMs and advisers. The truth is, the ultimate responsibility does sit with advisers, except where the DFM is fully integrated into the process. The reality is that both need to work together to make sure the end client is alerted to the state of their portfolio in a timely manner.
Often, advisers using DFMs on platforms do not have access to client data or indeed performance. This means that by definition, they are relying on the DFM to inform them when a drop happens, so they can in turn, fulfil their Mifid II obligations and report the drop to the end client.
While this is not the norm for DFMs, at Fundment we work with advisers to establish a process that ensures clients are notified within the qualifying time period. With our retail permission, though we are not direct to customers, we are able to generate a rapid and customised email. The email is copied to the adviser so all parties are kept informed. We also monitor the portfolios and notify advisers if the portfolios get within 80% of the regulatory 10% mark.
The more common option is for the DFM to inform the adviser, who in turn reports the portfolio drop to the client. This tends to be a slower process, with the drop in value message needing to be communicated through several different layers.
Plans should be in place to ensure compliance with the 10% rule in the event of a market correction or major world event. In my opinion, the obvious solution would be to harness the power of technology and ensure protocols are drafted to automatically alert end clients to a drop in their portfolio.
Without this, there is the very real possibility that certain breaches would not be flagged within the deadline. An example: a portfolio crosses the 10% drop line on a Friday afternoon. Despite this being picked up by the DFM and passed to the adviser in good time, it is now 4.45pm. This means it is unlikely the adviser will be in a position to pass the notice onto the end client before the end of the business day. In fact, this may not even be dispatched until Monday. The result? Mifid II is breached.
Every portfolio has days where it loses money and days where it makes money – that is the nature of our business. Mifid II simply means we must be quick to notify clients and manage the effect on them, which could be very negative if panic is allowed to take over.
Ola Abdul is founder and CEO of the automated investment platform Fundment