How a PROD is breaking the suitability lockdown for sustainable wholesale/retail fund sales

Adoption of MIFID2 advisory rules could be a game-changer on investor take-up

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Whilst financial advisers in the wholesale and retail space are currently doing their best to comprehend and manage client fears arising from the COVID-19 crisis, another pressing issue remains unresolved; that of responsible investing and ESG. 

Much like COVID-19, advisers may find themselves out of their comfort zone.

There has been a raft of ESG regulatory changes globally in the institutional space. 

But financial advisers in the wholesale/retail market had largely been ignored when it came to responsible investing. 

However, recent rule changes from the Financial Conduct Authority (FCA) regulator in the UK now necessitate a significantly more hands-on approach by advisers. The FCA calls it ‘PROD’. Other European countries will have their own versions for MiFID2. 

The reach of MiFID2 across all EU member states and UCITS markets, and even further afield into markets that use EU domiciled products such as Hong Kong and Singapore, cannot be underestimated. 

In doing so the EU leads the world on integrating ESG suitability into the advice process, leaving markets like the US, Canada, South Africa and Australia playing catch-up. 

And taking a close look at the UK regulation is instructive.

What is PROD?

PROD rules actually came into effect in January 2018, and are effectively the FCA Handbook for implementing the EU Markets in Financial Instruments Directive (MiFID). But implementation has taken time to come to the fore. 

Part of MiFID II added new statements to the rules such as: “Where ESG considerations are relevant for the provision of investment services to clients, firms should take them into account.”

PROD is made up of two stages. Stage one is for investment fund providers. 

Stage two – a suitability test – involves individual advisers meeting with clients or segmenting clients into groups to allow a more tailored service. This includes clients who are seeking responsible investment products or wish their current portfolio to be rotated towards a more responsible aim.

How PROD breaks the suitability lockdown

Until recently, the retail funds industry was stuck in a suitability lockdown, based on a presumption of choice and advice. 

For years, fund providers couldn’t access the customer without going through an adviser. And advisers were not proactively advising ESG and sustainable products because the suitability rules were not explicit, customers had limited information from advisers and product distributors were slow to change; this being generally a market that is demand-driven from advisers. This created a huge circular problem. Most fund providers had been offering some sort of responsible product for years but with only low take-up.

PROD changes the suitability requirements so that the lockdown is broken and customers are able to interact and engage on responsible issues. Indeed, if advisers don’t respond quickly enough then we may see more investors move to direct forms of investing.

Greenwashing: fair, clear and not misleading?

Following PROD, if advisers are going to start recommending responsible financial products then they need to get on top of ‘greenwash’. For financial advisers it was alluring to think providers were doing enough, but most were simply buying time, such has been the rapid debate shift in recent years. 

Part of the problem though is the taxonomy of terms that confront advisers today: ethical, faith-based, ESG, VBI, SRI, green, TCFD, PRI, EBI, CESR, social impact, SDGs, responsible investing etc. In many ways our collective rush to describe the problem has become the problem itself. It has created ambiguity and misrepresentation. 

Another form of greenwashing is for an asset manager to take an existing product; centralise and integrate an ‘ESG process’, then rebrand the same product as ‘ESG' and charge a premium. In reality the differences against legacy products might be minimal but the costs are not.

Building client consent for responsible investing

Consider that the societal acceptance of the COVID-19 lockdown arose from a clear empirical case presented around contagion and infection rates. When it comes to climate change we have seen governments take much softer approaches, with reliance on the private sector and a gradual creep of regulation and guidance.

Advisers thus need to seek consent from clients by allowing them to make an informed decision.

Under MiFID, we must already contact clients when their portfolios drop by 10% in value. 

Just imagine if the same applied when the ESG rating on a portfolio fell or carbon sensitivity rose. It won’t likely ever happen, especially until the taxonomy and data are worked out, but advisers can engage customers as if it did. 

Some ideas for financial advisers keen to address these issues, but unsure where to start are:

1. Engage your clients: the obvious and the best starting point

2. Ensure your suitability report covers customers’ preferences on issues like climate change and social issues, and pull together a group of questions to compliment your Attitude to Risk (ATR) questions

3. Review your products and portfolios. Create a segment for clients that wish to invest more responsibly. You will need to create different ATR portfolios within this; just as you would normally

4. Ask your own professional body and providers what they are doing to support advisers e.g. investor guides, online training as part of your CPD or modular courses and webinars

5. Keep an eye on the PRI website:

6. Ask your product provider about their responsible investment framework and what steps they are taking

7. Check if your providers are PRI signatories; if they are then they should be checking your fund managers

8. Check if your provider is using an ESG rating agency – which will hopefully be the majority of your fund managers.

9. Build your empirical knowledge from institutional forums like the Institutional Investment Group on Climate Change (IIGCC).

10. Review the pricing of ESG and responsible products against the wider market and your client median. Compare active and lower cost index products.

If, like COVID-19, climate change is seen as something that threatens your customers’ social and financial future then the scope to change the suitability model becomes possible. Following PROD, we need advisers to truly move retail investing forward into a new fund order.

JB Beckett is an ex fund selector, Non Executive Director, Emeritus of the Association of Professional Fund Investors, external specialist for the Chartered Institute for Securities and Investments, guest lecturer and author of a variety of books including ‘New Fund Order’.