The FCA announced in its recent asset management and alternatives portfolio strategy letter that it will start a multi-firm review of model portfolio services (MPSs) this year. The timing for this review, and whether it will land this side of the summer, remains uncertain for now.

What is clear is that the FCA intends to examine how MPS providers are applying the Consumer Duty, and issue good and bad practice guidance, in light of its findings. If the FCA does not like the consumer outcomes it identifies, it seems likely it will follow up with firms on an individual basis. 

So, will this be a repeat of the regulatory scorched earth we saw when the Consumer Duty was reviewed in the adviser, and to an extent, platform markets? 

There’s certainly a prospect that the MPS review could lead to substantive “Consumer Duty” driven changes across this market. It also won’t be the first time that the FCA has honed in on MPS and questioned their outcomes for consumers. In its DP 23/2 discussion paper the FCA observed the growth of MPS and questioned whether it should “apply a consistent set of rules for management of both funds and individual portfolios”. FCA implied “investors in portfolios might be harmed by not receiving the right level of protection” because many rules and protections that apply to fund managers do not also apply to MPS providers, despite a perceived similarity in these offerings. 

Against this background, an MPS probe is a natural progression in FCA’s Consumer Duty supervision. These services are becoming ever more popular and widespread in the market and so it’s not surprising they are to be examined. Developments in technology may make them easier and quicker to launch and run. They are also not expensive for clients in comparison with a full discretionary investment management service. 

But there are some regulatory risks which pose a potential threat to firms in delivering these services. 

For a start, they need to be properly structured and described. Different variations of MPS have cropped up over the years and some of these might be seen to stretch the model and particularly the contractual structure to the point it may no longer work. Time will tell whether these arrangements will pass muster with the FCA. To explain this, it makes sense to talk about the basic structure of an MPS. Fundamentally, an MPS is offered to a client by a collaboration between two firms (an IFA and an MPS provider), neither of which typically has the FCA permissions to deliver the service on its own to the client. Specifically, the MPS provider doesn’t generally have retail client permissions. Only the IFA facing the retail client, has those permissions. However, the IFA is usually only able to provide advice and doesn’t have “managing investments” on its FCA permissions (meaning it is more lightly capitalised as a non-MIFIDPRU firm). The result is that the retail client receives a service that no single party involved has the regulatory permissions to provide, without the other. Of course, there are other retail wealth services where this is also the case (like model B custody services) but what’s a bit more unusual with an MPS is that the client only has a direct contractual relationship with one of the firms involved (the IFA). Whilst this structure has not so far been challenged by the FCA, the suitability implications of it need to be properly implemented. The MPS should apply two separate suitability assessments: one on the retail client by the IFA and one on the IFA by the MPS provider. Both of them should be tailored and bespoke assessments, robust and well documented. Even though the suitability assessment on the IFA will be for a professional client and subject to COBS 9A assumptions, corners should not be cut.

From a legal and contractual perspective, these services can sometimes also be tricky to position with clients in a way which makes it easy for clients to understand: (i) “what they are getting” and “from whom”; and (ii) to whom they will have recourse contractually if things were to go wrong. This is partly tied up with the rather technical structure as outlined above and misunderstandings between parties about the scope of the so-called “agent as client” rule for the MPS. 

Potentially there are also other reasons to fear some bad weather for some MPS providers following FCA’s Consumer Duty review. Notably:

• the MPS may not be investing in a wide variety of investments: it may be channelling into one or a small number of fund products, sometimes managed by the same group as the MPS provider. The MPS may also be offered by a fully vertically integrated group and cross-sold from advisory services. In some circumstances these arrangements can generate potential conflict of interest risks; 
• the relationship between the IFA and the MPS provider and required amount of collaboration and flow of management information may leave something to be desired. Does the IFA really understand the model portfolio buckets and what is in them and what they represent for the client; and
• ultimately the suitability assessment is not always done well and is not always appropriately documented. The labelling of the model portfolios may also arguably be unclear or mis-leading for clients. Clients may not be in the right services for them and an MPS may not be right for them at all. Some clients may be in full discretionary services to whom an MPS would be better suited, but the reverse is also true.

It’s difficult to predict exactly what FCA’s good and poor practices will be but we anticipate that the following will help firms to shelter from future bad weather.

• Ensure there is a co-manufacturing agreement between IFA and MPS provider. Since two firms typically deliver the proposition (and bearing in mind the extended definition of “manufacture” under PRIN 2A versus PROD), it seems likely the FCA will expect co-manufacturing agreements. This co-manufacturing agreement should be a “second generation” agreement and not just a table copying out and allocating the duties listed in PRIN 2A. Consideration also needs to be given to the relationship with platforms in this context and the contractual agreements with those counterparties.
• Settle a clear target market for the MPS and take care to identify and monitor sales outside that target market.
• Collect and scrutinise management information on the conflict risks of MPS being sold in vertically integrated IFA groups. Mitigate the risks of any conflicts. Particular attention should be paid to the risk that individual advisers may be incentivised personally to recommend the MPS due to any form of benefit they receive (whether or not this is technically “remuneration”). Firms should monitor for churn and excessively high MPS recommendations. Care should also be taken when scoping and implementing deferred consideration structures in M&A transactions in this market.
• Ensure the MPS provider does not contract with the retail client for the MPS. If it does it will owe a suitability assessment on the retail client and not the IFA and must do a full retail client suitability assessment.
• As MPS provider, never outsource the suitability assessment to the IFA. Ensure that the disclosures about the contents of the model portfolios are clear and not misleading.
• Conduct a strict fair value assessment on both MPS provider and IFA charges, applying an objective, reasonable and data led pricing methodology which can be justified to the FCA. Take care when deviating from a “cost to serve” approach to calculating pricing or allowing significant price differentiation between services which are in practice the same or similar. MPS need to be compared to the pricing structures applied under discretionary investment management services and not just viewed in isolation.
• Be careful when describing the “agent as client” structure to clients. The MPS provider does not owe anything like the same regulatory protections to the IFA under its contract with the IFA as it would if instead it had contracted directly with the retail client. Care is needed to describe the model to clients transparently and in a way which meets their information needs under the Consumer Duty.
• Where a vertically integrated group has both IFA and MPS provider in the same MIFIDPRU consolidation group, a careful risk assessment should be completed under the ICARA, which takes full account of the risks posed. 

Returning to DP 23/2 it is to be hoped that the FCA approaches the MPS review appreciating the key differences between MPS and authorised retail funds. DP23/2 appeared to view retail licensed fund products as broadly the same thing as an MPS, but with each receiving different and unequal regulatory treatment between them, for no reason. In our opinion, DP 23/2 did not acknowledge the differing approach of the two EEA sectoral directives MiFID and UCITS, from which the “inconsistency” FCA highlighted above, was derived. Fundamentally, a licensed retail fund and an MPS are different propositions and there is a regulatory quid pro quo inherent in these two different models. An authorised retail fund is subject to a highly prescriptive regulatory framework under COLL. However, unless that fund is accompanied by other services, it offers no personal or tailored suitability assessment for the individual investor. It is a product off the shelf in that sense. In contrast, an MPS lacks the granular protections under COLL and indeed, the COLL Handbook has no direct application at all to those services. However, there are protections under COBS: an MPS is a service which ultimately offers clients a personal suitability assessment. As noted above, two suitability assessments should typically be done under the MPS: one assessment by the IFA on the retail client and another, different assessment on the IFA by the MPS provider since the IFA is the MPS provider’s regulatory client. 

Please contact us if you would like a copy of our MPS good and poor practice paper to help you prepare in advance for the MPS review. If you would like to discuss your MPS in confidence with us, including the pricing, contractual disclosures and structure in advance of the FCA review, please contact us using the details below.