2017- Preparing for change

06 February 2017

Fraser Donaldson – Insight Analyst (Funds and DFM)

Learning objective – reminding advisers that there will be significant change in regulation at the end of 2017.

It is traditional at this time of year to look back over the previous 12 months and see if we can get an indication of the way the industry is heading over the next year. 2016 saw both Markets in Financial Instruments Directive (MiFID ll) and Packaged Retail and Insurance-based Investment Products (PRllPs) delayed for a year, now not due to come in to force until 2018. This gives an indication of the importance and far reaching effects of this legislation. RDR ll if you like!

It feels like this delay gave our own regulators the opportunity to have their own say on the asset management industry, publishing The Asset Management Market Study, Interim report, back in November. For me, this will turn out to be the most significant event of last year.

MiFID ll and PRIIPS will push the industry in to greater transparency, particularly in terms of costs and charges, and equally importantly ensure, through improved governance, that suitable products are sold to investors.

The Asset Management study questions the industry on the level of its charges, and in doing so suggests that clients are not getting value for money. They highlight that passive funds are lightly used, despite being a cheaper option than active funds and are arguably better value for money. The cost of passive funds has come down over the last 10 years. The cost of active funds has not.

In the Defaqto DFM service review, only 13% of advisers surveyed preferred passives. The rest either preferred active or had no preference.


The main issue it seems is that there has been no incentive or pressure to lower the cost of active funds. For instance, the study claims that more than half of investors are not aware that they are paying any charges at all! One of the USPs of passive funds is that they are low cost, so investor and advisor focus is on this aspect. The claimed USP of active funds is for outperformance (of a benchmark), so price tends to remain in the small-print. The study also casts doubt on whether this outperformance actually exists. Source: Defaqto DFM service study 2016.

Assets under management (AUM) in the active sector has grown significantly in the last 10 years and technology has come on leaps and bounds, so it is a fair question to ask where the benefits of economies of scale and technological efficiencies are going. It seems not to the benefit of the client.

The positive news here is that we are already witnessing a real intent by some active managers to cut costs. It is a difficult circle to square as cutting costs means cutting profits – on the other hand, not cutting costs may well mean losing business, particularly if the costs of active remain in the spotlight. Some tricky conversations with key shareholders are going to take place and human resource may be the sacrificial lamb here.

If active funds are seen as poor value, and passives are not quite the adviser/client cup of tea, it is just possible that the relatively low cost compromise of smart-beta funds may become an attractive alternative.

Perhaps with the new transparency brought about by MiFID ll and PRIIPS, together with the FCA’s obvious warnings in its study, 2017 will bring the first green shoots of downward pressure on the price of active funds, although I expect it to be a gentle decline rather than a full out pricing war.

In other news, we continue to see the slow creep of firms becoming vertically integrated, owning more than one link in the distribution chain. In principal a good idea, if you have the resource to do so. Controlling, say, both asset management and adviser distribution ought to mean more synergy between the two, developing products for a known market.

This is not unrelated to the first half of this article in that products (funds or DFM) should be more cost effective to run and distribute and hence cheaper than the market average. Some, if not all of these savings should be passed on to the client.

The question in my mind is what happens if internally run funds start underperforming significantly. Will firms stop using them in favour of externally run funds? Most active houses go through extended periods of underperformance, if not in all, certainly some asset types. It is going to take exceptional corporate boldness to stop using or even moving out of your own funds. Evidence of independent governance, looking after the clients’ best interests, will be important in structures of this nature.

Evidence of this structure benefiting clients in terms of service and cost may determine how successful vertical integration will be. We look forward to the debate over the coming year.

Finally, referring back to the asset management study, there was almost a throw-away line in there which said ‘We also have concerns about the value provided by platforms and advisors and are proposing further FCA work in this area’. It seems no-one is safe!

Despite being sorely tested in the past, I am still optimistic that the industry will do the right thing. Remember who the industry is serving, and always put the customer first. Be transparent, exhibit integrity and ensure that all links in the distribution chain do the same. In other words, treat the customer fairly and this should ensure and maintain the clients trust. Easy!

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