Vertically integrated firms continue to make a loss on advice arms, but change might be afoot
For larger advice groups, vertical integration remains the model of choice. Integrating advice, wealth management and platforms, they argue, gives a better service to the client, tighter management of risk and allows servicing of a broader range of customers. Tighter integration avoids multiple vendors and complexity. Vertical integration may still be in its infancy for some firms, but is fund management pulling the strings?
For some time, fears have existed about cross-subsidy, whereby a captive advice arm is propped up by a higher-margin fund management business.
The FCA is clear that this is against its rules, stating that “the allocation of costs and profit between the adviser’s charge and product cost should be such that any cross-subsidisation is insignificant in the long term”.
It has also more recently confirmed that “long-term” should be defined as no longer than five years.
There is a secondary problem, which is more difficult to prove: that the advice element primarily exists to drive clients into in-house funds.
As one expert puts it: “These firms make money getting assets into expensive funds. They make their margin on funds. They subsidise their fund sales effort through restricted advice.” The result? The client may not be getting the right funds and may be paying too much.
To see if these challenges stack up, Money Marketing has dug into the numbers again.
Leaving the losses out there
We have conducted a similar study in each of the past two years, and the situation remains the same: many large vertically integrated advice businesses still make a loss on their planning operations, while platform or fund arms run at a profit.
St James’s Place has to some extent set the model for vertical integration and many envy its margins and market capitalisation. But its results are clear: it made £1,151.6m on its fund management business and lost £38.9m on its distribution business in the year to December 2018. This is even more stark than the previous year, when it made £1,044.4m profit on its fund business and its distribution business lost £31.9m.
There are some reasons for this. The group says it invests heavily in its academy for new advisers and paraplanners, and it has put £44m into its back-office infrastructure.
Elsewhere, the gap is not as clear. Tavistock made a loss on its advisory support business this year, having made a profit last year. However, the group divested a number of poorly performing advisory businesses over the year, knocking overall revenues and increasing expenses, but hopefully improving profitability on that side of the business over the longer term.
Lighthouse, recently bought by Quilter, was profitable in 2018. But despite the rapid growth in its investment arm, Luceo Asset Management, which went from £37m to £58m in funds under management by the end of 2018, it contributed a £300,000 loss to the group.
At fund behemoths like Standard Life Aberdeen or Aviva, the wealth arms are just a pinprick in the overall funds and platform businesses. The combination of advice business 1825, technology provider Focus Solutions and compliance company Threesixty contributed just £43m to Standard Life Aberdeen’s overall revenues of £1,868m last year. Whatever its intentions in the long term, as it stands, it is not the advice business making the difference for the group.
Others such as Hargreaves Lansdown – which almost certainly would not classify itself as a vertically integrated firm and is known best for its direct-to-consumer business – have also quietly built up adviser numbers. In Hargreaves’ case, this stands at around 100. But again, for the time being, the advice side is a relatively small piece of the group’s overall revenues; its funds business makes £103m, while “other” revenue streams – which include advice – make just £23.2m.
Cost creeping up
There can be little doubt that running an advice business can be expensive when compared to a fund business, particularly with regards to liability for misselling.
This is clear from the accounts of various groups. Aviva’s annual report this year noted that it had increased the amount set aside for customer redress in relation to historical advised sales by Friends Provident to £250m, up from £75m, even though over 90 per cent of cases identified were from before 2002.
IFG Group, which owns platform James Hay and advice business Saunderson House, has the opposite problem, as it has incurred its liabilities on the platform, not planning side, of the firm. In 2018, it set aside £5.5m in ongoing compensation and investigation costs over legacy sales of biofuel scheme investments on James Hay.
But the fact remains that advice businesses need to pay higher and higher regulatory costs, while there is a limit to the number of clients advisers can service well, so there are fewer economies of scale.
The Lang Cat consulting director Mike Barrett says: “The argument for vertical integration is that you can service a wider range of clients with greater diversity of needs. However, you still have to ensure individual suitability. The regulation looks at the individual proposition: are companies putting people into in-house funds that are not quite suitable? Could there be some shoe-horning?
“The regulation is clear that companies can’t rewind the clock to pre-RDR where the adviser sat down with the client and said that the advice was free, but in turn they got a kick-back from the product provider.
“Advisers have to make an explicit charge for investment business – they’re not allowed to receive commission from the provider. However, importantly, it doesn’t mean larger organisations can’t have different resource streams.”
Vertical integration still needs to evolve
A lot of people have tried to copy the largest vertically integrated firm, but no one has yet achieved its success in terms of valuation or market cap, or profitability.
The problem is the skill and management capability it takes to run a distribution, fund management and technology business. It’s quite challenging and it’s difficult to achieve synergy.
Given modern technology, it is possible for small advisers to achieve much the same economies of scale and efficiencies.
With a customer relationship management workflow system and client portal, I can link to the platform of my choice. I’ve got the same technology with 100 clients as someone has with 1,000 clients. And which is more nimble? I can get a good deal on prices and pass it on to the customer.
However, to my mind, it isn’t the vertical integration that is the problem. In theory, it could offer advantages to clients. It is simply that it hasn’t been done particularly well to date.
The problem is that they’re simply not using it for the benefit of customers as it stands. Vertical integration isn’t right or wrong. A really good firm could use its scale to deliver value. It’s like a Skoda or Audi. Essentially, they are the same thing, but people are happier to pay more for an Audi. For many clients, their view is ‘I’ve got no idea and this person helps me’. As such, it is hard to compare what a good outcome is – is it service, or performance, or advice?
Auto-enrolment may encourage a change in perception. Today, there are millions with only small amounts, but soon there will be millions with larger amounts, who will start to look closer at price and performance. Slowly but surely, this may change the dynamic.
The other option would be a large US player – Vanguard, for example – offering an alternative. If they replicated their offering in the UK, it may be as little as 80 basis points. This would be hard to ignore.
David Norman is founder of TCF Investment
The regulatory tide
There are no rules against a business offering advice and asset management as long as the costs and services are explicitly disclosed. Barrett points out that the largest firms have “close and continuous supervision” from the FCA: “The regulator is looking at everything they are doing. Any problems would be picked up at an early stage. The processes they’ve got in place internally to manage conflicts of interests are significant – there are Chinese walls.”
This suggests that if there are problems with cross-subsidy, the regulator is on top of them, but what about the related problem –that people are being directed to funds and potentially paying more for them? The profits of the asset management business may not be supporting the advice arm, but advisers could push people into funds that would be bought cheaper elsewhere.
Syndaxi Financial Planning director Rob Reid says: “The problem with a vertically integrated firm is that some of the costs are not particularly visible. There’s definitely cross-subsidy, even when they’re making losses on their investment management businesses, but finding what it has cost is difficult.”
He believes it is important to work towards a point where comparing costs is easier, but does not see it happening imminently. Will the FCA’s recent work on value for money statements make a difference? He is not sure there is a lot of will to change or to look at the problem creatively on the part of the FCA. But for Reid, the problem is that consumers do not understand what they are getting.
This is a key problem – clients have little objective judgment on whether what they receive is good or not. Most of the time, they just know whether they feel they are getting the care and attention they deserve and whether their wealth in retirement meets their expectations. “Does the means justify the end? Is going into an in-house fund the outcome the client is happy with?” asks Reid.
SJP, for example, has plenty of happy clients. For most clients, they may not be highly knowledgeable of concepts like relative investment performance and costs, but do understand when they feel someone is taking care of their wealth.
In a recent video, SJP clients shared on LinkedIn what it felt like to be advised by the firm. It was not about performance or cost – or the difference between advice and fund management – but about how the adviser made them feel about their wealth. While clients of SJP – or Sanlam, Intrinsic or Tavistock – are happy and believe they are receiving appropriate advice, there is little will to change exactly how these firms are structured. Nevertheless, the FCA’s value for money attestations may make a difference. These come in at the end of this year.
The FCA says fund managers “should assess and justify to their fund investors the charges taken from the funds they manage in the context of the overall service and value provided. They must assess the value for money of each fund against a non-exhaustive list of prescribed elements, conclude that each fund offers good value for money or take corrective action if it does not, and explain the assessment annually in a report made available to the public.”
TCF Investment founder David Norman says: “The FCA is also bringing in independent directors on fund boards. At this point, investors might say, ‘I’m buying this fund, a UK equity fund and underneath is Neil Woodford. Why isn’t it the cheapest?’ The firm may say, ‘but we provide better service’ – that’s the fund, the service is separate.
“The whole point of pooled assets is economies of scale. If there aren’t, what’s the point? Is alpha scaleable?”
He agrees that the FCA’s value for money drive could have some teeth: “It’s early days. It’s been announced. Asset managers will have to publish something at the end of this year. What will they say? It’s underperformed but it’s really good value?”
Chief executive of Novia Financial, which operates a platform and discretionary manager through its in-house arm Copia, Bill Vasilieff, says: “There isn’t a ‘best’ model, but transparency is a good starting point. The FCA is clear that it won’t say what the price should be, but its intervention on ‘value for money’ should make firms more transparent.”
There is nothing wrong with a vertically integrated firm, as long as the clients are seeing benefits from the economies of scale it produces.
Adviser technology is now so good, others argue that it is possible to achieve similar outcomes as a non-integrated firm, so it is important to justify the structure to clients.