Although some of the asset management industry’s more opaque fee and disclosure practices have long been panned by consumer bodies and other organisations, the UK Financial Conduct Authority (FCA) stopped short of imposing wholesale reform in its final paper, issued in June.
So scathing had been the regulator’s Asset Management Market Study in November 2016 that the industry had been braced for the imposition of an all-inclusive fee structure and stringent measures to improve transparency and strengthen price competition.
In the event, the regulator settled on making asset managers disclose all actual fees and estimated costs to clients and promised a further consultation, which will report back on December 2017.
There will also be a working group looking at improving clarity around funds’ objectives and the use of benchmarks and performance reporting.
The FCA remains concerned that charges are inconsistently presented and are often opaque, and it may have been unable to reach a conclusion, particularly around transaction costs, which are central to full transparency.
The proposal to provide transaction cost estimates will mean investors still end up paying for any variance from that estimate, although persistent underestimating will be easy to identify and perhaps even penalise.
Furthermore, while there are explicit charges such as the costs of dealing and stamp duty, the implicit costs of spread and implementation shortfall are more challenging to account for precisely.
The plan is to build on the revamped Europe-wide Markets in Financial Instruments Directive (Mifid II) and Packaged Retail and Insurance-based Investment Products regulations (Priips), which focus on the expectation of a fixed cost and estimates of transaction costs and will be implemented in January 2018.
Mifid II will be extended to the whole fund management industry, not only the intermediaries where the European regulation actually applies.
Both Mifid II and Priips will require pre-sale generic disclosure well before a product’s sale.
But Mifid II is more extensive and covers the cost of ongoing services provided around the products, such as distribution and advice, discretionary management, trading, research and reporting.
Moreover, the calculation of a fund’s transaction costs differs under the two regimes – the market impact is included in the Priips calculation but not in the Mifid II calculation. How these will be fully aligned is not yet clear.
“Neither Mifid nor Priips achieve what needs to be achieved, they are an artificial simplification,” says Daniel Godfrey, co-founder of The People’s Trust and the former chief executive of the Investment Association who was effectively ousted by Schroders and M&G Investments in October 2015 for trying to push through precisely these types of reform.
“We should do better – a single all-inclusive charge including research, and then an additional execution cost estimate for dealing and stamp duty, and we should keep managers on the hook for that, perhaps fining them if they go over by say 20%.”
Making transaction charges explicit should discourage asset managers from overtrading, at a time when they spend about £3bn of their clients’ money on dealing commissions per year. But while transaction costs could be estimated in advance, no methodology is perfect and some managers may overestimate in order not to be caught out subsequently.
Likewise, some might underestimate and be reluctant to trade when they should do. Another downside is dealing with one-off or unpredictable events; for example, when a portfolio needs to be repositioned because the economic backdrop shifts.
The FCA also found that some £109bn is invested in closet indexers – funds with a tracking error of below 1.5 that still charge handsome fees – and has promised a clearer statement on strategy and targets and when managers are deemed to have succeeded or failed.
“Many fund managers are just being paid to control tracking error,” Mr Godfrey says. “They pay to buy shares in which they are underweight, which immediately presents a conflict of interest as these are shares they do not like.”
While charges for passive funds have fallen, fees for active management have scarcely reduced over the past 10 years, and tend to be set around certain price points, between 0.75% and 1%, when arguably they should have fallen as economies of scale have become greater.
The FCA is investigating how to make it easier to switch investors into cheaper share classes. In a hint at the behind-the-scenes disagreements, FCA chief economist and director of competition Mary Starks said on launching the report:
“We have had lengthy discussions with the Investment Association, which would rather we looked at a three-year period, which shows a tail-off in active fees, but over the longer run of 10 years this is imperceptible.”
The regulator is also seeking to end the practice of funds making so-called box profits, fees managers generate through the dual-priced funds structure.
This has already prompted Jupiter and Schroder to move to single pricing – creating a £13m hole in Jupiter’s profits – but leaves others such as Liontrust Asset Management in a dwindling pool of big retail managers still operating the structure.
In terms of reporting past performance, poor practices among fund managers include omitting certain funds from the sample quoted, not using appropriate benchmarks and reporting performance gross of fees.
David McCann, an analyst at Numis, has been taking managers to task on these issues, which has encouraged managers such as Henderson Global Investors and Premier Asset Management to reveal the precise percentage of assets under management (AuM) included in their headline performance statements.
“No doubt the FCA faced a lot of emotive arguments for different approaches,” McCann said. “But most commercial companies take a risk in their pricing. I am disappointed that there were no concrete measures in this report, which was supposed to be final. It’s a big missed opportunity.”
There is particular confusion about the benchmark used by the 100-strong absolute return fund sector, as many of these funds use riskier strategies, but some among their number produce marketing material simply showing returns against cash.
A minority of asset managers charge performance-related fees, which at least is a move away from the ad valorem fee model, in which managers collect a percentage of AuM regardless of performance.
“Some clients like performance fees,” explains Nick Sykes, partner and European director of consulting at Mercer.
“The reservation is that they are not symmetrical i.e. managers don’t lose as much as they gain. You may like small boutiques with higher performance but they often cap the mandate size, and limit capacity after two to three years, so the managers need performance fees to make enough money.”
Asset managers have also been warned by the FCA for failing to give clients value for money for research, having long lumped together the fees they pay investment banks for research, such as analyst notes, with trading costs and passed these on to investors.
Mifid II will require asset managers to set separate budgets for research and trading, and decide whether to charge clients for research or pay for it themselves.
However, research providers are failing to engage with groups on pricing setting, according to a survey by Fintech firm RSRCHXchange.
While over half of asset managers have at least begun to set their research budgets and choose a payment method, 23% have not received pricing information from any of their providers (data collected during Q2).
Sykes says that some asset managers still charge clients for research such as access to a CIO.
“If research is charged to the investor, that would be something that we would not be enthusiastic about,” he says. “One or two managers have even quite recently asked us to pay for research after fees.”
There are countless pieces of research stretching back decades showing that while active managers sometimes beat the benchmark, the returns from any outperformance are typically eroded completely by the fees charged and furthermore while outperformance is rarely repeated, poor performance has a dogged persistence.
Back in 2008 Cuthbertson showed that among equity funds there are a few top performers and a multitude of poor performers and that past performance is indeed no guide to the future.
That echoed previous work by Fletcher & Forbes in 2002, which looked at unit trust performance from 1982-96 and discovered that any degree of outperformance was followed equally swiftly by a period of underperformance.
Regarding transaction fees, in 2000 Quigley and Sinquefield found limited outperformance in equity unit trusts and that to achieve it required 80% turnover that would have wiped out any gains.
“There is greater evidence and more acceptance now that active management is hard-pressed to deliver in efficient markets such as the US, but is the only option in certain asset classes, such as emerging market bonds and some private markets,” says John MacDonald, senior manager research consultant at Hymans Robertson.
“We would say that arguments should be framed around efficient and inefficient markets. Pension funds increasingly use passive for the core with some active satellites. While there is now a greater focus on charges, there is no evidence to suggest much has changed yet. I guess that will only happen when asset managers are coerced.”