The Financial Conduct Authority (FCA) has published an interim report on its asset management market study. It found evidence of high profitability relative to market benchmarks and weak price competition, especially in actively managed retail investment funds. The FCA’s proposed remedies are primarily intended to improve the transparency of fund charges and fund performance, reform governance standards for UK authorised funds, and increase scrutiny of the unregulated investment consultancy market. The FCA also proposes to carry out further research on how asset management services and products are distributed to retail investors. The regulator is seeking feedback on its proposals by 20 February 2017.
The FCA found weak price competition and low consumer awareness in the asset management market. Around half of retail investors in a recent FCA survey were not aware that they were paying fund charges. The FCA found that whilst competition had driven down charges for passive funds, charges for active funds had hardly changed over the past ten years. The FCA did not find a clear relationship between fund charges and investment performance, and found that “on average active funds underperformed their benchmarks after charges”. The regulator observed that profits for active management were higher than for passive management in absolute terms. The FCA found that asset managers’ operating margins averaged 36% over the past six years after paying salaries and bonuses to front-line staff. Adding back some staff costs to reflect the sharing of economic profits with front-line staff, the FCA estimated an operating profit margin range of 30-60%. The FCA observed that these margins were high compared to a 16% average margin for firms in the FTSE All share index.
The FCA found that investment consultants helped institutional investors choose asset managers which met minimum quality and operational standards, but did not appear to help investors identify better performing managers or drive down costs.
Key remedies proposed by the FCA included:
- “All-in” fund fees: One option is to require asset managers to charge an “all-in” fund fee which includes transaction costs, and to bear any additional transaction costs incurred. This would go significantly further than the revised Markets in Financial Instruments Directive (MiFID II), which requires increased disclosures on transaction costs. Asset managers would have to bear any transaction costs which were higher than planned, and the FCA noted that this could result in their trading less than would be optimal for investors. Hence the FCA is considering allowing asset managers to charge for “overspend” in exceptional circumstances. In either case, the inclusion of transaction costs in an “all-in” fee would increase fixed charges, making funds seem more expensive than at present.
- Strengthened governance: The FCA is considering placing a duty on the Boards of managers of authorised funds (AFMs) to demonstrate how their funds deliver value for money, and reforming governance standards for UK authorised funds. Potential options for the latter include requiring AFM Boards to have a majority of independent members and an independent chair, creating an additional governance body modelled on independent governance committees for defined contribution pension funds, or replacing AFM Boards with majority independent fund boards. Increased independence of board or committee members could increase the likelihood of a portfolio manager being replaced if it did not offer good value for money.
- Clearer disclosure of fund charges: The Packaged Retail Investment Products Regulation (PRIIPS) will require firms to provide investors in UK retail funds with an estimate of charges they may incur in pound amounts. The FCA proposes to reinforce this by requiring fund charges to be disclosed in pound amounts in other literature from the fund manager, from advisers and on platforms. The FCA is also considering requiring asset managers to explain more clearly the impact charges have on returns on an on-going basis, and to disclose the total cost of investment (including distribution) pre-sale and on an on-going basis. While MiFID II and PRIIPS will both introduce more detailed disclosures on costs and charges, the FCA’s proposals could make the summary cost figures more prominent and clarify the distinction between fund and distribution charges.
- Clearer disclosure of fund performance: The FCA proposes to require fund managers to set more specific fund objectives, to provide information on whether performance objectives are met (including disclosing managers’ benchmarks), and to explain the performance of funds that have merged or closed. If the FCA’s further work finds a pattern of persistently underperforming funds, it may “shine a light” on these or require asset managers to tell investors when their funds are underperforming. These measures could lead to increased levels of switching.
- Making it easier to move into better value share classes: The FCA proposes to “shine a light” on the differences in charges between share classes, experiment with different communications to encourage investors to switch share class, and make it easier for asset managers to bulk transfer investors to alternative share classes where it is in their best interests. Increased switching to cheaper share classes could reduce margins for some asset managers.
- Investment consultants: The FCA proposes to refer the investment consultancy market to the Competition and Markets Authority as it found limited scrutiny of asset allocation advice provided to institutional investors and potential conflicts of interest. It also proposes to recommend to HM Treasury that this market is brought within scope of FCA regulation. This issue was previously considered by the Law Commission, which noted that under MiFID II generic advice cannot be regulated unless strict criteria are met. Nevertheless, there could be more flexibility following the UK’s vote to leave the EU. An increased focus on value for money in this market may benefit those asset managers which are not currently recommended by investment consultants.
The FCA’s proposed remedies are likely to increase awareness and hence scrutiny of fund charges and investment performance, which may in turn put pressure on margins and accelerate the existing trend towards passive investment strategies. Increased segmentation in the market may also result, with active funds deviating more from indices to differentiate themselves further from cheaper passive funds. Asset managers will need to review the competitiveness of their offerings, with a particular focus on higher margin and underperforming products. In response to increased margin pressure, firms may rationalise their product range to focus on larger funds in order to benefit from economies of scale.