In the next few months, the UK regulatory body, the Financial Conduct Authority, will publish a sweeping final report on the country’s £7 trillion asset-management industry, calling for more competition and reduced investor costs. An interim report, Asset Management Market Study, released at the end of last year flagged weak price competition and found asset managers were making profits from underperforming funds. It was a forewarning of a damning final verdict on the sector, £3 trillion of which is managed on behalf of UK pension funds and other institutional investors.
The FCA’s sights are set on active management in particularly.
The regulator argues that actively managed funds have high costs that are not always justified by high returns. It states that the majority of active funds do not beat their benchmark, and in a study of two funds – one active and one passive, both earning the same return before charges – estimates that over a period of 20 years, the passive fund could yield a return 44 per cent more than an actively managed equivalent, because of costs.
Since 2005, passive funds have experienced nearly five-fold growth. They now represent about 23 per cent of the assets under management in the UK. Yet the FCA estimates that the annual average fee for actively managed equity funds is 0.90 per cent of AUM, in contrast to the average passive fee of 0.15 per cent. Transaction costs are normally higher for active funds, too.
“Our analysis shows mainstream actively managed fund charges have stayed broadly the same for the last 10 years,” the watchdog states. “Few asset-management firms told us they lower charges to attract investment; most believe this would not win them new business.”
Pricing not competitive
The FCA has also flagged “considerable price clustering for active equity funds”, something it believes is consistent with firms’ reluctance to undercut one another by offering lower charges. As fund size increases, prices don’t fall, suggesting the economies of scale are captured by the fund manager, rather than being passed on to investors in these funds.
Actively managed investments don’t necessarily outperform their benchmark after costs either. The FCA states that investors choose funds with higher charges in the expectation of achieving higher future returns. However, there isn’t any clear relationship between price and performance; the most expensive funds do not appear to perform better than other funds, before or after costs.
Absolute return funds are also in the regulator’s sights. The FCA has two concerns with these funds, which aim to deliver a positive return whatever the market conditions. First, it states that many absolute return funds do not report their performance against the relevant returns target. It has also criticised these funds for charging performance fees when returns are lower than the performance objective. “The manager is rewarded despite not achieving what the investor considers to be target performance,” the FCA asserts.
The FCA wants greater transparency and standardisation of costs and charges for institutional investors. This could include the introduction of an all-in fee approach to quoting charges, so fund investors can easily see costs. Investors pay a management fee along with other costs of running a fund, yet not all of these charges are made clear. For example, only one in five investors knew they footed the bill for trading costs, the FCA states.
The regulator also has found that investors are not always given information on transaction costs in advance, meaning they cannot take the full cost into account when they make the initial investment decision.
“We have concerns about how asset managers communicate their objectives and outcomes to investors,” the FCA states.
Fee transparency is certainly an issue on the radar of the UK’s pension industry.
“Our members say fee information and reporting from private equity and hedge funds are particularly opaque and difficult to access,” says Luke Hildyard, policy lead, stewardship and corporate governance, at the UK’s Pensions and Lifetime Savings Association. “We believe the [Institutional Limited Partners Association] Reporting Template could be a good basis for the FCA to build upon,” he says, referring to ILPA’s first standard fee reporting template for the private-equity industry.
Consolidation for pension funds
Trustees of pension schemes, and other committees that oversee institutional investments, can face a range of challenges in their dealings with asset managers. These include low and variable levels of investment experience on the committees and resource constraints.
That situation is behind another recommendation expected to be in the final report. The regulator will extol the benefits of greater pooling of pension scheme assets amongst the UK’s thousands of small defined contribution schemes. It believes there is “a relationship” between some of the challenges facing oversight committees and their size; smaller schemes have fewer resources and are less knowledgeable. Pension schemes with more funds also have a better bargaining position; smaller schemes are less able to secure discounts from asset managers.
“The influence these small schemes have over asset managers is pretty minimal,” Hildyard says. “Consolidation is something we have supported for a long time.”
Finally, the FCA also has its sights set on consultants.
The regulator states: “There are a wide range of investors in the institutional market. This includes many small pension schemes [that] rely heavily on the advice of consultants. We have found concerns about the way the investment consultant market operates.”