The U.S. Securities and Exchanges Commission, SEC, and Luxembourg financial supervisor CSSF have jointly voiced significant concerns about “increasingly complicated fee structures” in the fund industry, warning that these practices may be obscuring the true costs for investors.
Addressing an audience of American lawyers and investment managers at the Alfi Roadshow conference in New York on Thursday, Robert Shapiro, assistant director of the SEC’s investment management division, said fund managers on both sides of the Atlantic are earning fees at multiple levels from their products or their funds, sometimes concealing the rationale behind them.
“We want to understand if the fee structure is being properly communicated to clients and whether or not the fees are consistent with what is being disclosed,” Shapiro said.
One example of tweaking the fees for clients is the increased use of leverage by some funds, which could increase the costs for investors. Shapiro added that the SEC is also examining how the valuations of underlying assets factor into these fee structures. The criticism applies mostly to the management of alternative investment funds, used widely for private equity, debt and real asset investments. Luxembourg is home to more than 14,000 of such funds that are held by investors worldwide.
Conflicts of interest in valuations
CSSF director Marco Zwick, who joined Shapiro on the panel led by Alfi director Jean-Marc Goy, said that on-site inspections in Luxembourg revealed conflicts of interest where portfolio managers sometimes act as valuation appraisers.
“Sometimes managers will claim that asset valuations are conducted internally, but upon closer examination, we often discover that much of this process is actually outsourced,” Zwick noted, highlighting the discrepancies between their statements and actions. “While managers can delegate various activities, they cannot delegate their oversight responsibilities.”
Alfi is the Association of the Luxembourg Fund Industry and represents the sell-side part of the fund and asset management industry in the grand duchy. The association brings together fund and legal professionals throughout the year and hosts road shows globally to promote Luxembourg investment fund vehicles.
The regulators’ increased scrutiny of fund fees and valuations comes at a time when asset managers face escalating fee pressures and the imperative to differentiate themselves in an increasingly saturated market. In Luxembourg, CSSF has been calling for more transparency on fees for some time. A November 2022 CSSF review of fund costs drew strong criticism from the industry.
Competition and fee compression
Over the past decade, the fund industry has seen a proliferation of new products and strategies, leading to heightened competition and fee compression as investors increasingly turned to lower cost products. This environment has driven managers to seek new ways to maintain profitability, sometimes resulting in more complex and less transparent fee structures.
Revenue growth for the industry was a paltry 0.2 percent in 2023, sharply contrasted by a 4.3 percent rise in costs and an 8.1 percent drop in profits, according to the latest research from the Boston Consulting Group.
This underscores the importance of transparency and fairness in fee structures, as investors and regulators alike push for greater accountability in the industry.
Fees need to be logical, says SEC
“If you say you are doing something, you better be doing it,” Shapiro said. He acknowledges the challenges in valuing illiquid assets but emphasizes that the SEC needs to ensure that fee structures are logical and that clear policies and procedures are in place.
“The changes in interest rates and increased volatility are affecting portfolio management, and we need managers to take that into account in a way that is considerate of their clients’ best interests and consistent with what is being advertised,” he said.
“It’s easy to run a great fund when everything is going smoothly. It’s when things get rocky that the problems start.”
At the Alfi New York roadshow, Shapiro and Zwick discussed a wide range of topics relevant for the fund industry in Luxembourg. Among them, also the need to comply with new cybersecurity regulations in the European Union, as per the Dora package that enters into force next year.
“If you get Dora wrong, it will seriously harm your operations,” Zwick said.