At the end of June the UK’s Financial Conduct Authority published its final report on the asset management market study. This is a significant milestone on a journey that is already over 18 months in duration – comprising terms of reference, extensive data gathering, an interim report and consultation period. However, the journey is far from over – particularly for asset consultants.
What do regulators want?
OK, so the FCA doesn’t speak for all regulators – but the title works better in the abstract. First, the FCA wants market forces (competition) to be the primary source of discipline on investment firms, in that it wants “to make competition work better in this market”. Second, it wants to “protect those least able to actively engage with their asset manager”. It is hard to argue with either of these points, and both point to the purpose of the Institute – to make the investment industry work better for the end saver.
However, it is worth adding that the FCA believes there will be follow-on benefits from achieving these two aims, namely they “will increase efficiency, lead to the UK asset management industry being a more attractive place for investors and so improve the relative competitiveness of the UK market”. If true, it will be incumbent on regulators in other markets to follow quickly so (1) the ‘global end saver’ similarly benefits, and (2) the UK’s improved relative competiveness is short-lived.
What did the FCA conclude?
- Price competition is weak, particularly within retail. There was clearly an attempt during the consultation period to overturn this conclusion, but the FCA uses a 36% average profit margin to conclude that “price competition is not working as effectively as it could be”.
- On average, neither active nor passive funds outperform their benchmark after fees. This finding applies for both retail and institutional investors.
- There is some evidence of a negative relationship between net returns and charges. Paying higher charges for funds leads, on average, to worse results.
- It is difficult for investors to identify outperforming funds. Partly because it is difficult to interpret and compare past performance, and partly because past performance is not a good indicator of future performance (good performance is not persistent).
- There is some evidence of persistent poor performance of funds. However poorly performing funds are more likely to be merged or closed. If merged, subsequent performance tends to improve, but the performance of the recipient fund tends to deteriorate.
- The FCA has concerns about how asset managers communicate their objectives. It estimates that there is around £109bn in ‘active’ funds that closely mirror the market, at significantly higher cost. The (unstated) implication is that these ‘active’ managers should be communicating their intention to match the market return – but charge an active fee for it.
- Investors’ awareness and focus on charges is mixed and often poor.
- The FCA has concerns about investment consulting. These include the relatively high and stable market shares for the three largest providers, a weak demand side, relatively low switching levels and conflicts of interest.
- Retail investors do not appear to benefit from economies of scale when pooling their money together. The FCA doesn’t like this, which leads us to…
What to do?
The resulting actions, or ‘remedies’ in FCA-speak, can be grouped a number of ways – according to the objective they are targeting, or how final they are (some are final now, some are being consulted on now, and some will be subject to future detailed consultation). This explains why this particular journey will continue for quite some time yet.
Improving investor protection
A) Strengthened duty on asset managers to act in the best interests of investors, which may include value-for-money considerations, and will include some level of independence in governance structures.
B) Requirement to return ‘risk-free box profits’ to the fund. Why was this not happening anyway?
C) FCA to make it easier to switch investors to cheaper share classes.
Increase competitive pressure
D) A single, all-in fee for investors. For an industry that makes its living from predicting the indefinite future, predicting transaction costs over the next 12 months shouldn’t be too difficult.
E) Standardised disclosure of costs and charges to institutional investors. This one is for the industry to develop, under the care of an ‘independent person’.
F) The FCA will chair a working group to make objectives clearer (and how benchmarks and past performance are used).
G) Recommendation that the Department for Work and Pensions (DWP) remove barriers to pension scheme consolidation (economies of scale and greater bargaining power).
Improve the effectiveness of intermediaries
H) Make a final decision in Sep 2017 on referring investment consultants to the Competition and Markets Authority. So, from September, the big three asset consultants in the UK will either need to abide by their voluntarily offered ‘undertakings in lieu’ of a referral – or will face a likely two further years of investigation.
I) Recommendation that the Treasury place asset consultants under the regulation of the FCA. Again, why are consultants not already regulated?
J) The FCA will launch a new market study into investment platforms, to assess the state of competition in that market.
What to make of all this?
We could be kind and conclude that being a regulator is a really tough job, and a thankless one at that. Which would be true. We could also conclude the FCA’s motives are good and the changes are in the right direction (but I am somewhat underwhelmed by the strength of the bite of the proposed changes). My own priors also lead me to the conclusion that there is considerable scope for investment organisations to take a principled leadership position and go beyond the letter of these remedies to really reshape our industry for the benefit of the end saver. For example, am I the only person who finds it shameful that we need to be instructed to return risk-free box profits to the owners? If we wish to become a trusted and respected industry I think there is further to go than suggested by the FCA. These changes should be the minimum required of us.
However, from reviewing this final report, my dominant impression is how little the regulator understands parts of the industry under its regulation. What I can’t decide is whether a lack of understanding on the part of a regulator is shocking and inexcusable – or predictable and understandable as nobody possesses a complete understanding of all the moving parts. I don’t know the first thing about pay levels within regulators, but in the US the transition from regulatory body to high-paid Wall St position is a well-documented career path. I imagine the situation must be broadly comparable in other countries. In my opinion, a strong economy needs a well-functioning investment industry, and a well-functioning investment industry needs strong and thoughtful regulation. It could be in our best interests to wish for more, and higher-paid staff at regulators that understand the industry better and enforce stricter standards of behaviour.