Whom this blog is intended for: Fund managers’ board and c-suite; risk and compliance teams, and those interested in income funds and the asset management sector more generally.
Length to read: 8 minutes
- Income funds face a number of discrete regulatory challenges due to the reduction in interest rates and, in particular, equity dividends triggered by the COVID-19 pandemic.
- These include communicating carefully with clients, particularly recognising that their expectations may not have adjusted fully to the changed income outlook; maintaining adequate fund liquidity; and ensuring that the firm can continue to demonstrate that it is treating its customers fairly.
- Any changes in investment strategy aimed at offsetting the squeeze on income will require careful prior assessment of any potential increases to the fund’s risk profile, and whether the change is consistent both with the fund mandate and investors’ understanding and reasonable expectations.
2020 had been forecast to be a strong year for income investors. The FTSE 100 has typically paid out a yield of circa 4% compared to the S&P’s circa 2%, making the UK a traditionally attractive market for equity income investors. However, the unprecedented economic shock of COVID-19 has led to a sharp reduction in the dividend outlook globally. In the UK more than 40% of companies have already announced either reductions or suspensions of dividend payments, with more companies expected to follow. At the same time, nominal interest rates have fallen to new lows creating further pressure on bond and cash returns.
These developments pose a challenge to many income funds who may consequently struggle to meet their funds’ objectives. They also pose wider social challenges, particularly in relation to the rising proportion of pensioners who, with the growth of defined contribution pension schemes and further falls in interest rates, depend increasingly on the dividend flow from equities for a significant part of their retirement income. Given that this group may include many who are vulnerable, the situation also raises significant considerations and challenges for regulators.
Against this background, managers of income funds may look to invest in alternatives to traditional income stocks and consider shifting their overall asset allocation strategies, and potentially their risk profiles, in an effort to maintain returns.
In this blog, we consider the challenges income funds are likely to face as a result of this changed income outlook and assesses the potential regulatory risks and considerations associated with the pursuit of alternative investment strategies.
For our analysis of the COVID-19 related regulatory issues applying to the investment management sector more generally, please read our previous blog.
Regulatory challenges for income funds given the economic impact of COVID-19
It is currently far from clear that retail investors’ expectations have adjusted fully to the changed dividend outlook. Accordingly, a key challenge firms will face is communicating clearly how changes in market conditions are likely to affect the fund and its ability to generate income. Firms will want to balance the need to keep investors fully appraised of the situation and to provide them with a fair and accurate account of events, against not wanting to cause unnecessary alarm or distress. Firms should be mindful of the FCA’s PRIN 7 which requires them to communicate in a way which is “clear, fair and not misleading” and, as always, will want to consider how they can communicate in an effective manner whilst avoiding any personal recommendations that stray into the realm of advice. Firms can, however, take advantage of the FCA’s relaxation of rules around the MiFID 10% portfolio value drop notifications and only send one such notification to clients.
Whilst communicating with customers will be paramount, firms will also need to have discussions with both their depositaries and auditors to ensure they are kept appraised of the fund’s situation and any potential action taken by the fund manager. Funds will want to consider regularly reviewing their portfolio of investments to pick up on any companies cancelling or reducing their dividends, to ensure they can communicate promptly any further changes in the income outlook.
Whilst many income funds will be mainly invested in highly liquid equities, liquidity nonetheless remains an important regulatory concern.
The FCA is stepping up its scrutiny of fund liquidity positions and has emphasised that firms must inform them promptly if they foresee or are experiencing liquidity challenges. Funds would benefit from pro-actively reviewing their liquidity management toolkit to ensure that it is sufficient to address sudden and large redemption requests, and examining how they would approach asset valuation and liquidity management in any renewed bouts of market turmoil. They will also need to consider, including via stress testing, the liquidity risk implications of any changes in investment strategy made in response to current market conditions.
Generating income and fund strategy
Despite the reduced dividend environment, firms will be understandably keen to try and maintain their income pay-outs as far as possible, and may be thinking laterally as to ways to do so. One possibility mooted is taking out a loan against a fund’s capital in order to assist income payments, with a view to paying this back in future as dividend income recovers. However, any borrowing, particularly that of longer or uncertain duration, may well conflict with COLL 5.5.4 and 5.5.5, which regulate investment firms’ ability to borrow. Additionally, the FCA has been clear that firms should not distribute capital that could credibly be required to absorb losses over the coming period, and so would be likely to have concerns about such borrowing.
Given the reduced dividend income from many equities, funds may also consider seeking income from alternative sources, raising the question of how far funds would be able to modify their investment strategy and remit in order to meet their overall yield targets. Any such changes may well have implications for the fund’s risk profile. A key question is whether the broad purpose and mandate on whose basis investors have invested to date, as well as investor suitability more generally, would be maintained if an alternative investment or asset allocation strategy were pursued. Alternative assets may well have higher volatility and illiquidity risks, particularly in less stable markets. Furthermore, a number of sectors that have maintained dividends are trading at high premiums to net asset values, creating potential additional valuation risks. Other approaches, such as using derivatives or synthetic products to increase leverage or widen asset exposure, come with other material risks and may be outside the scope and remit of the investment vehicle and its suitability requirements.
When considering changes to their investment mix and looking at alternative sources of income, fund managers should be mindful of not fundamentally altering the nature of the fund, lest they fall short of their suitability obligations or breach the provisions of COLL 4.3 and trigger the need for an extraordinary resolution from unit holders. Funds will also need to ensure that any significant investment strategy changes, and their risk profile implications, are communicated clearly to investors.
Treating customers fairly
Firms will no doubt be mindful that many of those most likely to be invested in income funds are older and potentially more vulnerable consumers, who are largely reliant on the income these funds provide to pay for their retirement. The FCA will be particularly concerned about any potential harm or detriment to these consumers, and will respond quickly should it consider that they have been treated unfairly. Consequently, firms will want to ensure not only that they are doing everything possible to put their customers first, but also that they can demonstrate this comprehensively. They should also be especially alert to any business decisions that may be perceived as unfair or even as profiteering from the crisis. Any such actions are likely to carry high levels of regulatory and reputational risk.
Qualifying as an income fund
Many firms were initially concerned that the changing economic environment and fall in dividend income would mean that they might fail to qualify as income funds, as they would not be able to achieve the yield of distributed income necessary to meet the classification criteria rules of their trade body – the Investment Association. However, the Investment Association, responded quickly to firms’ concerns and suspended the yield requirement for funds within its UK and Global Equity Income sectors.
This change should help ensure that fund managers do not face any extra pressure to sell certain stocks which have temporarily suspended dividend payments, nor feel forced to switch into a small number of companies who are able to continue to pay dividends. In the light of this, firms may want to re-visit their normal buy and sell criteria for their income funds, at least until the present crisis abates, to ensure that they are not crystallising losses unnecessarily and purchasing more expensive investments that continue to generate income during this downturn.
At present many expect the current reduction in dividends to be temporary and for things to return to “normal” after a given period of time, albeit there is increasing debate about the likely profile, timing and extent of the recovery. While demand for income is likely to remain strong among retail investors, if the current health emergency persists for longer than expected and the economic effect of the crisis continues to grow, firms may want to revisit product design, and importantly, their communications, to reflect the challenges of this new post COVID-19 reality and the risk of persistently lower dividend levels.
Close and open ended funds
Close ended investment trusts may be better placed to continue to pay out during this period, at least for a while. Unlike open funds they are not required to pay over all income they receive and, consequently, many have built up significant reserves which can be used to smooth out income payments. Close ended trusts also have greater freedom to invest in less liquid assets which could be used to generate alternative sources of income. As such, the challenges explored above are generally likely to be greater for open ended funds, at least in the short term.
Implications for firms
While some of the issues posed by the COVID-19 pandemic, such as fund liquidity and redemptions, will be common across the investment management sector, income funds face a particular set of challenges.
Firms will need to monitor carefully their liquidity, communicate clearly and accurately to investors on the dividend and income outlook generally, and think through, and again communicate clearly and comprehensively, how any potential changes in investment strategy are likely to affect their end investors and the overall suitability of the fund.
Firms should also ensure they can demonstrate how they are putting their customers first and treating them fairly. If this reduction in dividends persists firms may also need to consider adjusting their wider product strategy to offer alternative investment products less reliant on dividend income.
 Under MiFID II, portfolio managers have a regulatory obligation to notify their clients if the value of the client’s portfolio drops more than 10%. In a March 31 Dear CEO letter to firms, the FCA said that it has “no intention of taking enforcement action where a firm has issued at least one notification to a retail client within a current reporting period” so long as the firm continued to provide publicly available updates through their website or other channels