OUR PROFESSION

CONSULTATION RESPONSES

 

 

Our Profession

Consultation Responses

Response from the Association of Independent Financial Advisers to FSA Consultation Paper 07/6 - Funds of Alternative Investment Funds (FAIFs)

Introduction

The Association of Independent Financial Advisers (AIFA) is the trade association that represents independent financial advisers (IFAs).  AIFA currently represents over 75% of IFA firms in the UK.

The IFA sector is the dominant distribution channel for retail financial products in the UK, generating over 65% in monetary value in 2006.  As such, the addition of FAIFs to the broad range of retail products currently advised on by AIFA members is a welcome opportunity to add innovation and diversity to a thriving market.  We therefore support the FSA’s response to changes in the market place and share its concern with ensuring that appropriate consumer protection is balanced with sufficient access to the full range of appropriate investment products. 

Executive summary

The growth in hedge funds internationally and especially in Europe, warrants FSA’s proposals to open up the UK retail market for these types of investment. The UK must remain competitive and a world leader in financial innovation. In addition, the recent bear market has seen an increase in the demand for less volatile investment products and advisers recognise that the traditional range of products advised upon may not always be the only appropriate strategy for every client.  

The make up of FAIFs, their attendant risks, and the ‘hedge fund’ techniques employed by FAIF managers obliges distributors to rise to new challenges as this type of product enters the mainstream market.  Pure product knowledge can be ‘rolled out’ by providers via the normal new product launch vehicles. AIFA’s concern, especially in the light of the split-caps debacle and the opacity of certain derivative based investments, is that advisers in this market must have comprehensive and wide investment knowledge to ensure these products are sold and serviced in an acceptable manner.  To this end, we would expect that these products are distributed only by advisers with appropriate qualifications and experience.  Whilst in practice, many advisers servicing the type of client likely to invest in FAIFs, will be suitably qualified, the danger will be in how they are marketed to advisers. We are pleased that FSA has been particularly emphatic on the responsibility of providers to ensure distributors have clear, comprehensible information.

AIFA shares the FSA’s acknowledgement that most retail consumers will not understand the complexity of these products and we are therefore supportive of FSA’s move to assess the current regulatory arrangements to ensure that both market and consumer confidence remain solid in this rapidly changing environment. 

We agree with the FSA’s assessment that retail-oriented FAIFs should be introduced into the well-regulated NURs regime.  The key to the successful distribution of FAIFs, however, will be clarity over the investment strategy and associated risk of the investment, and accessibility to funds.  This will present a significant challenge owing to the multi-layered nature of the products and the ability of managers to invest substantially in other unregulated funds.  Ultimately, the key messages to potential investors must be kept simple.

The paper refers to selection by providers of appropriate distribution channels. We agree that care must be taken to ensure that those who recommend these products have the right level of knowledge and skills. Whilst this responsibility lies with the advisory firm, we agree that the provider should be able to be more selective in which distributors to use. We would not however, expect selection criteria of distributors to be based on anything other than professional standards. Selection based on commercial interests but dressed up as something else will create competitive disadvantages for advisory firms and their clients.

The responsibility of advisers to ensure that clients are entirely happy investing in funds where returns are heavily reliant of the skills of the manager and adherence to stated investment objectives goes without saying.  

By its very nature, however, any Fund of Funds can deviate over time from its original profile.  Ensuring transparency and regular updates throughout the lifetime of the product must, therefore, be the foremost design consideration if FAIFs are to be distributed and serviced successfully.  Because of their esoteric and complex nature, AIFA’s view is that FAIFs should only be sold on an advised basis and with the offer of ongoing service. 

Specific Questions

Q1:  What types of product do you believe are likely to be developed as FAIFs, making use of the wider investment ability into unregulated schemes?

It will be up to providers to respond but AIFA’s desire is that the type of product should be transparent, risk assessed, stress tested and with information made comprehensible to the distributor.  AIFA strongly supports FSA’s requirement for stress testing and agrees that the information then given to advisers should show, for example, returns that are ‘probable’ rather than simply ‘possible’.  Advisers must be able to rely upon the information given to them by providers, and in turn they should ensure they fully understand the products, challenging any areas of uncertainty. AIFA therefore supports the FSA’s emphasis on the mutuality of responsibilities.  In such a sophisticated product group, the degree of trust the distributor and consumer are placing in the provider is very high.  Providers must acknowledge this by being absolutely candid and transparent in all communications with distributors and consumers.  The type of product likely to be developed as a FAIF is down to product developers and the market – our overriding concern is that its qualities stand up to stringent testing.

Q2:  To what extent is it likely that the FAIF proposals would be used to create ‘hybrid’ schemes where unregulated schemes are held along with other NURS eligible assets, as opposed to pure funds of funds?  What types of ‘hybrid’ scheme do you foresee being produced?

AIFA’s concern again, is that the structure, objectives and management of the fund are transparent and stress tested.  The market will decide on the quantity and style of hybrid schemes and whilst we agree that the envisaged due diligence approach to regulation is consistent with the move towards more principles-based regulation, this market will need (at least initially) close scrutiny by FSA to ensure that the products are being marketed and sold in a fair and transparent manner. 

Q3:  Are there any other matters not covered in the due diligence guidance on which guidance is needed?  Please specify.

Due diligence guidance is proportionate and responsible as long as a degree of consumer protection equivalent to that applied to Qualified Investor Schemes (QIS) can be achieved.  The priority is for advisers and consumers to be able to rest assured that the FAIF manager is competent and subject to appropriate regulation. 

Q4:  What is your view about our proposal to approach the valuation question in the way suggested, bearing in mind the need to ensure that the prices of the FAIF must be accurately calculated? 

AIFA strongly agrees that an independent valuation is necessary to give investors the reassurance that its published prices are accurate.  It will also allow distributors to advise with greater confidence than they would if valuations were not carried out independently.  We are not convinced that reliance on high level principles and due diligence provides sufficient protection for investors. We question whether FSA should reduce its standards on independent valuations just because they are not required by the US. If US providers wish to enter the UK market, they should be required to meet UK standards – at least until there is an established market with some track record to evidence the degree of risk these products actually present to UK investors and the behaviour of both providers and distributors.

Q5:  What is your view on the appropriateness and workability for FAIFs of a six month limited redemption provision?

We support a six month limited redemption provision.  As investors in FAIFs will typically be the more sophisticated investors who may well have property funds in their portfolio, the concept will probably not be new to them.  In our view, as long as the redemption provision applied is made absolutely clear and prominent in product literature and suitability letters, it is up to the client and adviser to assess the appropriateness of the product.

Q6:  Is a notice period required for FAIFs in addition to the existing limited redemption provision?  If there were no notice period allowed, would FAIFs be likely to invoke deferred redemption provisions?  If so, what is your estimate for the frequency of doing so?

We support the proposal not to allow notice periods. We are unable to comment on the impact this may have of increased use of deferred redemption activity.

Q7:  Do you agree that the normal NURS redemption payment standards should be applied to FAIFs?  If not, please give reasons.

We agree that the normal NURS redemption payment standards should be applied to FAIFs.  Consistent standards increase awareness and confidence.

Q8:  What are your views on our proposed approach to side pockets?

No comment.

Q9:  What are your views on our proposed change to the ’15% rule’ making it a matter for the NURS scheme’s manager to determine whether any scheme in which he might invest might in turn invest more than 15% of its assets in other collective investment schemes?

Despite the differing nature of hedge funds, there must be sufficient consumer protection to prevent any possible repetition of the ‘splits’ debacle. We support FSA’s preference for Option 2 which appears to give a reasonable level of protection against inappropriate cross-holdings. 

Q10:  What are your views on the proposed exception form the ‘15% rule’ for feeder funds, permitting a NURS to invest in an unregulated scheme that is itself dedicated to investing all of its assets into one ‘master’ scheme?

The existence of ‘feeder funds’ in overseas funds should not create a barrier to UK investment so we understand why FSA needs to address the rule. However as we do not have any expertise in this area, we have no further comments. 

 

Q11:  What are your views about the appropriateness of allowing NURSs to act as feeder funds?  Can sufficient controls be put in place in the interests of consumer protection, particularly where the master fund might itself be domiciled offshore?

 

We would support FSA’s decision not to let NURSs become feeder funds.  Until this market is sufficiently developed and has proved it can operate both ethically and compliantly, investors should not be exposed to any increased risks or loss of consumer protection. As fund of fund activity is necessarily multi-layered, customers must be afforded the safeguard of UK regulation.

Q12:  Should the 35% limit for FAIFs (as applies to other NURS) remain the same, be increased or reduced?

The requirement for a minimum of 3 underlying funds does deliver a consistent limit. However, due to the potential redemption restrictions, we would prefer (and expect) to see a higher number of funds to ensure adequate liquidity.

 

Q13:  What are your views on the proposal that FAIFs should be subject to the same borrowing limit as other NURSs?

We are broadly in agreement for reasons of ease of comparison and in order to ensure a ‘level playing field’ for providers.  The current limits are prudent and working so there is no reason to make an exception for FAIFs. 

Q14:  What are your views on the proposal to continue the existing aggregation of unregulated schemes with the 20% limit for unapproved securities?

We support the 20% limit for unapproved securities and continuance of aggregation. Again, there is the issue of disclosure. It will be necessary to fully disclose the nature of underlying investments and their associated risks.

Q15:  Are there any other NURS rules, which we have not identified, that should be changed to accommodate the development of FAIFs?  If so, please give full reasons as to why and how the rule would require amendment.

No.

 

Q16:  (a) What is your view on the draft rules included at Annex4?

(b) What is your view about the use of a due diligence approach in regulating the nature of the underlying investments of a FAIF?  What are your views on the due diligence Guidance proposed?

(a)  No issues that appear to be problematic from an advice point of view.

(b)  The due diligence approach is in accordance with the move to MPBR.  But it is more risky to apply the principle to a new market for retail investors which by its very nature is highly complex and could present greater risk than other product areas. For this reason, we would expect FSA to closely monitor the market both initially and on an ongoing basis as it evolves, until it proves itself to be fair and compliant.

Q17:              What are your views on the Case Study?

Background – FAIF scenario

We are firmly of the belief that FAIFs should only be sold on an advised basis.  The scenario outlines the level of generic investment demanded of advisers who need to understand advanced investment techniques such as short selling, derivatives, leverage and so on.  The other side of the coin is the obligation on providers to disclose all appropriate information about the product throughout its life cycle.  Such disclosure and clarity of explanation will be key to the success of any FAIF product. 

Distribution chain

As the FAIF is necessarily multi-layered, spread over many underlying funds and has reduced liquidity compared with many other types of investment, the responsibility again lies with the producer to disclose and explain the nature of the product and risks attached.  The material available to distributors and consumers should be stress-tested to ensure that the risk of mis-selling claims later on in the product life cycle are minimised.  Limiting the breadth of distribution channels initially is a sensible approach and will assist in achieving this.  But we refer to the comments made earlier regarding appropriate criteria for selecting distributors.

The scenario of an Adviser accepting the offer of a further promotional briefing on behalf of a Network seemed unlikely.  It is more likely that a Network would arrange for Appointed Representatives to be briefed and appropriately trained – typically at a seminar or workshop-style event.  We would support Networks imposing restrictions on which ARs are allowed to sell FAIFs – for example, only ARs with appropriate AFPC or equivalent qualifications for reasons outlined elsewhere in this response.  However, for directly authorised advisers, we accept this level of supervision would not be possible and other means of control may be desirable. 

It must also be noted that some national IFA networks, knowing the complex nature of FAIFs, may well refuse to allow their ARs to advise on them. 

Provider/Distributor Responsibilities

Product Design:  We strongly support the view that product design should be based on experience, resources and capabilities.  Providers should not feel under competitive pressures to push out an ill thought-out product into the market.  We completely support the type of stress testing as set out in the case study. 

Selecting and Managing Distribution Channels:  We also support the balance and rigour of responsibilities outlined in this sector and believe it to be proportionate and responsible.

Sales Process and Post Sale Responsibility:  The case study reflects an appropriate model.   As mentioned elsewhere, the offer of ongoing advice should form part of this process.

Q18.  Do you agree that the due diligence requirements will not impose additional compliance costs of more than minimal significance.

No comment.

Q19:  Do you have any other comments on the CBA?

We would agree that information asymmetries may occur between investment providers, distributors and investors and be more acute due to the propensity for these products to be novel or unique. 

Whilst we are happy to accept that direct costs for the FSA are capable of being absorbed within the business-as-usual model,  as we expect closer supervision in the early stages of establishing a market, costs may be higher than estimated. Providers may make additional requests for Treating Customers Fairly (TCF) guidance due to the complexity of the products and in order to minimise risks of mis-selling / mis-buying in the future.  It is hoped that such requests would receive a sympathetic hearing.

AIFA

June 2007

 

MEMBERS LOGIN

remember me ?

Password reminder

Not a member?   JOIN AIFA

AIFA has three prestigious meeting rooms available to hire.