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Money for old hope - Can the fund-management industry deliver a better deal for

2017-06-29 06:00:58

rlp

There will be more transparency on charges and better governance standards. But

how much in the fund-management industry will really change?

IMAGINE an industry where the average profit margins were 36%, where the

regulator found little evidence of price competition and where the average

person did not get the benefit of the lower charges available to the wealthiest

customers. You would probably expect the regulator to throw a book the size of

Thomas Piketty s Capital at it. The industry s executives ought to be as

nervous as a very small nun at a penguin shoot.

But that has not happened with the report of the Financial Conduct Authority

(FCA), Britain s regulator, into the fund-management industry, which was

published today. What the FCA proposes in terms of greater transparency of fees

and better governance standards is fair enough. But one wonders how much

difference it will make. The industry has reacted to the findings with

equanimity.

Perhaps the most damning of the report s findings is point 1.9

We find weak price competition in a number of areas of the asset management

industry. Firms do not typically compete on price, particularly for retail

active asset management services. We carried out additional work on the pricing

of segregated mandates which are typically sold to larger institutional

investors. This showed that prices tend to fall as the size of the mandate

increases. These lower prices do not seem to be available for equivalently

sized retail funds

Fund managers benefit from economies of scale; it does not cost ten times as

much to manage 100m as it does to manage 10m. But because they charge an ad

valorem (percentage) fee, managers get paid ten times as much for the former as

for the latter. Institutional investors (pension funds and the like) realise

this and negotiate lower fees for bigger sums. But the same benefits do not get

passed on to retail investors; the little guy. That helps explain why the

industry can earn such high profits.

One reason for this is that investors have not traditionally picked funds on

the basis of price; they are aiming for return. And that leads them to pick

funds on the basis of past performance; money for old hope. Surveys show

(including those in the FCA s interim report) that they are deluding

themselves; performance does not reliably persist.

Another reason is that the cost of fund management may not be clear in

investors minds; it is not like comparing bottles of milk. Some people

struggle with percentages and even for those who do understand them, the cost

in terms of hard currency may not be easily apparent; for a 10,000 investment

the difference between an active fund charging 1% a year and a tracker charing

0.2% is 80 a year.

And the annual fee is not the only charge; some funds trade a lot more than

others and this costs money. So the FCA wants to see an all-in fee revealed to

investors; something that is also under way (as of 2018) under an EU regulation

called MIFID II. (Yes, the EU often passes regulations, as with abolishing

roaming charges for mobile phones, that are consumer-friendly).

Admittedly, this is a complex area. Fund managers may be doing their clients a

service if they trade out of a losing position and the overall impact of

charges will show up in the net return. Hence there will be consultation before

the details of an all-in charge are revealed. Nevertheless, this seems to be an

area where sunlight is the best disinfectant.

Few will disagree either with the FCA s desire to strengthen the duty on fund

managers to act in the best interests of investors and to improve corporate

governance by having more independent directors.

But will this make an enormous change to the industry? If the findings were

about water or power supply, the regulator would have acted a lot more harshly.

However, those industries are natural monopolies and fund management is not.

There is an argument that regulators should accordingly insure that consumers

are better informed and let them choose for themselves.

The biggest impact on the British industry came with the retail distribution

review (RDR) of 2012, which outlawed the payment of commissions to advisers to

recommend funds. The effect of the old rule was to incentivise advisers to

recommend higher-charging funds (since the commission came out of the annual

fee). The effect of the RDR has been to create a distinction between clean

classes of shares (with no commission) and bundled classes. The Investment

Association, the industry s lobby group, says there has been a fall in the

average fee on clean shares from 0.99% to 0.92% in recent years. The FCA report

rightly says it should be easier for investors to switch to the cheaper, clean

classes.

Perhaps the most encouraging development has been the stepping-up of the

presence of Vanguard, the low-cost mutual fund giant, in the British market.

Before the RDR, it was hard for Vanguard to sell funds; now its business is

growing at 25% a year. But it is a sign of the poor competitiveness of the

British industry that Vanguard s market share is much higher in the US. The

remarkable thing about finance, compared with other industries like music or

telecoms, is how long it takes a low-cost operator to shake up the industry.

All index-trackers are not perfect; some charge too much and some indices are

not well-diversified (the MSCI World, for example). But as Warren Buffett

points out, they are the best option for most people. Retail investors can t

rely on the FCA to bring down costs; they will have to do it for themselves.