In November 2016, the FCA released their interim report regarding the Asset Management Market Study.
The FCA is reviewing the asset management sector in order to ensure that the asset management market works well and that consumers are able to achieve value for money. Areas which the FCA has covered in the Report include:
• the cost of investing and how asset managers deliver value for money;
• the transparency of investment objectives; and
• the role of intermediaries, in particular investment consultants.
The Report also examines the extent to which barriers to innovation (including regulatory barriers) are preventing investors from achieving better outcomes. The Report sets out the FCA’s findings to date and its current thinking on potential remedies. Overall, the FCA found that there is significant scope for improvement and we consider some of the FCA's key concerns below.
The Report highlighted the lack of price competition in certain areas of the industry, which can significantly impact the investment returns for investors as fees and charges are a drag on their returns. The FCA particularly noted that pricing for actively managed funds has broadly remained static for the last decade at an average of around 0.90% of the assets under management. This pricing is in contrast to that for passive funds, where the average price is 0.15%. Further, transaction fees tend to be higher for actively managed funds as well. These higher costs mean that an actively managed fund needs to materially outperform the market in order to make reasonable returns for its investors. Passive funds with their lower costs can make similar returns by matching market performance.
However, from its work with firms who provide actively managed funds the FCA found that such firms did not believe they needed to reduce their fees to attract new retail investors. On the other hand, in the passive fund sector (which has seen significant growth in the last decade) the FCA found that there had been material price reduction over the last five years. On this basis, the FCA believes that certain groups of investors are aware of price and conscious of the effect it has on their return on investment and that there is scope to increase investor awareness to improve price competition.
It is also worth noting that the Report states that the FCA found that there was no clear relationship between price and performance of funds, ie expensive actively managed funds did not generally outperform less costly funds. The FCA found that many active funds were effectively tracking the market at considerably greater expense to their investors than a passive fund with a similar (and express) objective to track the market.
Transparency and clarity of investment objectives and outcomes
Transparency has been a key theme in the asset management industry for some time now, although previously the focus was on transparent charging. The FCA notes that progress has been made in relation to making the cost of investing more transparent through the use of the ongoing charges figure (OCF) which gives investors an estimate of what the annual management fees and certain ancillary costs, such as administrative costs will be . The Report does express concern, however, that transaction costs are not always clearly disclosed to investors in advance and that such costs can add significantly to the cost of investing.
In addition, the FCA is concerned about the lack of clarity and transparency regarding the investment objectives and outcomes of actively managed funds. The FCA believes that there is a risk that investors continue to invest in expensive active funds which only reflect market performance because fund managers “do not adequately explain the fund’s investment strategy and charges”. The FCA has further concerns with how many absolute return funds report their performance, and with certain performance fee structures which allow managers to be rewarded when they have not achieved what an investor would consider to be the investment target.
Role of intermediaries, including investment consultants
The FCA examined how intermediaries affect the asset management market in both the retail and institutional sector. For the retail sector the FCA noted the growing use of platforms and tools like “best buy” lists which are used by retail investors to aid them in their investment decisions. Despite such growing use of platforms by retail investors, retail investors do not appear to benefit from economies of scale when pooling their funds through a platform. The FCA believes that platforms are not as successful at achieving discounts as they could be and that it appeared that investors have difficulty switching platforms. The FCA proposes to carry out further work on platforms outside the scope of the Report. In terms of the "best buy" lists, the FCA noted that such lists do not tend to give sufficient prominence to passive funds and that even the "best buy" funds did not tend to outperform benchmarks once costs had been taken into account.
For institutional investors, the FCA noted that the use of investment consultants influenced the choice of asset manager. The FCA also found that while the due diligence carried out by such consultants had some benefit it did not appear that these consultants helped institutional investors choose better performing managers or funds. Also, investment consultants do not appear to be able to help smaller institutional investors negotiate on price. The FCA noted that the investment consultancy market was a concentrated one and that clients did not tend to switch investment consultant. Further, the FCA believes that there is a risk of conflicts of interest between investment consultants and investors given that investment consultants appear to be moving into the fiduciary management arena (thereby giving rise to a temptation to recommend their own services) and that investment consultants appear to accept noteworthy amounts of hospitality from asset managers. The FCA is considering whether to refer the investment consultancy sector to the Competition and Markets Authority.
The FCA considered the use of benchmarks by funds and found that while many managers used benchmarks they were not always clearly disclosed, nor was the connection between the benchmark and the fund's investment objective always clearly set out. As a result investors, especially retail investors, could struggle to understand the fund's performance.
The FCA also considered how funds performed against benchmarks and its analysis indicates that for retail investors both active and passive funds tend to perform below their benchmarks once costs are taken into account. However, because of the higher costs associated with active funds investors in these funds are particularly vulnerable to poor value for money outcomes. With regard to institutional investors the FCA found that after costs the performance of such products did not differ from the benchmark. The FCA intends to carry out further work on benchmarks; in particular it will try to ascertain if benchmarks reflect the risk managers are taking on.
Barriers to innovation
The FCA has found that there has been some innovation in the asset management sector, although by and large change has been “evolutionary rather than revolutionary.” Firms have tended to harness technological developments to improve and refine their client offering, for example offering new ways to communicate with clients. The FCA, while noting that the asset management industry has flagged the weight of regulation as a barrier to innovation and identified the regulatory capital requirements and the cost of AIFMD compliance as particularly burdensome, has not offered any significant response to these issues.
The FCA puts forward a lengthy list of proposed remedies in the Report. Key proposals include:
• a strengthened duty on the part of asset managers to act in the best interests of their investors - in particular an obligation on managers to demonstrate how their funds deliver value for money for investors, and this obligation could be included in the Senior Manager and Certification Regime which is due to be extended to all FCA authorised firms in 2018;
• an all–in fee – there are 4 types of potential all-in fee proposed by the FCA, all of which are designed (to a greater or lesser extent) to move away from the "estimate" nature of the OCF to a firm figure which (in certain proposals) includes transaction costs;
• helping retail investors identify the best fund for them by:
- requiring asset managers to set clearer and more specific investment objectives and to provide a timeframe against which such objectives should be measured;
- clarifying and strengthening the rules regarding the use of benchmarks including possibly further requirements to disclose benchmarks and obligations as to how benchmarks should be used to illustrate fund performance and performance against objectives; and
- providing tools to help investors identify persistently underperforming funds, including potentially publicising persistently underperforming funds;
• making it easier for retail investors to move into better value share classes – in order for competition to work properly, investors need to be able to switch products easily if there is a better alternative available to them. However, there are several barriers to switching products, for example investors can face significant exit costs making it difficult for investors to figure out if they would actually be better off switching once all the costs were taken into account. The FCA proposes a number of remedies including raising investor awareness of expensive pre-RDR share classes.
In addition, as mentioned above the FCA is consulting on whether to make a market investigation reference to the Competition and Markets Authority on the investment consultancy market and whether the FCA should recommend to HM Treasury that such institutional "investment advice" is brought within the FCA’s regulatory remit. Further as mentioned above, the FCA is considering whether work is required in relation to platforms to ensure that they help investors achieve better value for money and more research into the use and effect of benchmarks.
Conclusion and next steps
The Report does not make for easy reading for the industry. Indeed, some of the findings may be regarded as quite surprising as they are focussed on real-life investor outcomes rather than firms' compliance with regulatory requirements and guidance. However, the Report can be seen as a reminder of the FCA's competition objective and duty, and the extensive powers it has available in this context.
The Report is clear that the FCA believes that there is still quite some distance to go before the FCA will be comfortable that investors, especially retail investors and smaller institutional investors are able to achieve value for money. Investment consultants are under the spotlight but the proposed work on platforms and benchmarks is also noteworthy. Parties who wish to provide feedback on the Report should do so by 20 February 2017.
The FCA has as one of its three operational objectives, the objective to promote competition in the interests of consumers. In addition under Section 1B(4) of FSMA the FCA has a general duty to promote competition.
The FCA has powers relating to competition under FSMA but also under the Enterprise Act 2002 and the Competition Act 1998.
If you require further information on anything covered in this briefing please contact Grania Baird (firstname.lastname@example.org; +44(0)203 375 7443) or Fiona Lowrie (email@example.com; +44(0)203 375 7232) or your usual contact at the firm on 020 3375 7000. Further information can also be found on the Finance and Funding Issues page on our website.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, December 2016