It seems an age ago now since the FCA’s Product Intervention and Product Governance Sourcebook (PROD) was brought in alongside MiFID II to improve the industry’s product oversight and governance process. The rules were introduced to tighten the requirements around the design and sale of products to ensure they meet the needs of identifiable target markets, are distributed appropriately and deliver good customer outcomes.
PROD contains a mixture of rules and guidance for both product manufacturers and distributors. So far adviser focus has naturally concentrated on the distributor requirements of PROD. This includes identifying client needs and in turn defining target markets to develop, document and review robust client segmentation strategies for example.
We carried out some adviser research earlier this year and found that a quarter of advisers surveyed had no formal, or informal, mechanism in place to segment their clients highlighting the ongoing difficulties behind this requirement. However, one of the most interesting angles within PROD is that some advisers are categorised as both a distributor and a manufacturer and this introduces a whole host of additional issues.
Life as a manufacturer
Advisers who build and distribute their own model portfolios are defined as both a manufacturer and a distributor in PROD. This is still the case even if the adviser is using an output from a third party asset allocation tool or blending multi asset funds.
There are 36 individual rules and pieces of guidance aimed at manufacturers and that is in addition to all of the various requirements aimed at distributors.
This inadvertently creates a number of additional challengers for advisers to consider which I believe boil down to three main themes:
- Ongoing due diligence of underlying funds and the portfolio
- Monitoring for ‘crucial events’
- Suitability of underlying funds within the portfolio
PROD places a requirement for both the underlying funds and the portfolio to undergo rigorous due diligence both at the outset and annually. This stringent obligation means drilling down into themes such as liquidity, cyber security and pricing errors to name a few.
This in itself pulls in a new set of additional challenges. For example, how are advisers meant to consider look-through across the various underlying funds into underlying holdings? X-ray reports on platforms can help to an extent but how many of these tools highlighted that Neil Woodford was holding a higher amount in illiquid assets and that’s just one example.
Ultimately, advisers will be expected to have in place a robust and wide-reaching due diligence process to cover the portfolio and the underlying funds used to populate the portfolio.
One of the most interesting rules in PROD is the requirement for manufacturers to review their solutions at regular intervals and this involves the identification of ‘crucial events’. ‘Crucial events’ are defined as those that would affect the potential risk or return expectations. This would therefore include monitoring for the portfolio crossing a risk/return threshold and also monitoring the solvency of certain issuers that may impact performance.
If such a ‘crucial event’ is identified, advisers would be required to take appropriate action which may consist of changing the product approval process and stopping further recommendations of the portfolio and/or underlying funds. Ultimately, advisers are required to complete regular reviews to make sure their solution is functioning as intended.
Due to the extreme daily swings we’ve seen in markets due to Covid-19, you could argue that the pandemic has thrown PROD’s first ‘crucial event’ into the mix. The FCA would expect product manufacturers to be actively reviewing the potential risk/reward characteristics of a portfolio in light of the increased market volatility. I can’t help but feel that this particular requirement places a significant and additional burden on advisers’ shoulders.
Generally speaking, an adviser may build a number of different model portfolios which are aligned to different attitudes to risk and clients are subsequently placed in the most appropriate and suitable portfolio.
The PROD rules dictate that manufacturers’ solutions need to meet the overall needs of an identified target market of end clients. Model portfolios may include a variety of different underlying funds which all contribute to the diversification and correlation characteristics of the portfolio.
Advisers would therefore need to ensure that the model portfolio remains suitable for the identified target market like balanced retail investors, for example. However, certain underlying funds within the portfolio may be targeted at more experienced investors and may not be suitable as stand-alone investments for the same target market as the portfolio. In this instance, adviser firms would need to have a robust process in place which ensures that underlying funds are only used as stand-alone investments where they are suitable for the end clients in which they have been designed for.
The European Commission’s latest consultation on MiFID II
Against this backdrop, the European Commission has just published its latest consultation on MiFID II. This includes a review into the effectiveness of the PROD rules and I don’t think that this should be viewed as a surprise in light of the challenges highlighted above for advisers.
Stakeholder concerns have already flagged a general feeling that PROD offers little added benefit to the suitability assessment. Concerns have also been raised around the lack of essential information needed to satisfy the various rules and requirements.
The consultation asks whether the rules should be simplified and is due to close in Q2 2020.
We welcome the European Commission’s latest consultation which includes a review into the effectiveness of the PROD rules. A great deal of clarity is still required to help advisers truly implement a robust and compliant PROD process.
Another interesting nod to PROD will be the planned introduction of investment pathways later in the year. The pathways can act as a useful guide when considering client life stages and how needs and objectives change as clients move into the income phase of their savings journey. This is certainly relevant in a post-PROD environment where the FCA is turning the focus back to client suitability.
2020 is a year of uncertainty and challenges and PROD continues to ask questions of advisers’ processes. That’s why it’s perhaps more important than ever to have a robust and documented PROD process in place which is reviewed on an ongoing basis.