The investment management industry is under pressure to reform cost structures following a damning report from the Financial Services Consumer Panel, which found it is failing to treat customers fairly.
This week, the panel called for urgent reform after independent research found current cost measures are a “poor guide” to the total costs paid by consumers, conflicts of interest are poorly managed and competition is not working effectively.
The panel warns the lack of cost transparency threatens to undo the good outcomes of initiatives such as auto-enrolment and the Budget pension freedoms by preventing consumers from making informed decisions about where to invest.
With a radical single charge solution proposed by the panel, and strict European rules on disclosure coming down the track, time is running out for the industry to find a solution to the transparency issues that have beset it for years.
The report is the latest in a series of indictments of the competition and transparency of the investment management sector.
In 2002, the Sandler Report on the UK retail investment market found the reporting of product charges was “neither clear nor consistent”. Last year, the Office of Fair Trading highlighted the opacity of charges in defined contribution pension schemes.
And in May, the FCA called on the industry to scrap annual management charges in favour of ongoing charge figures after finding fund groups were failing to display fees clearly and consistently.
The Consumer Panel commissioned two independent reports: one by global risk consultant Rajiv Jaitly and the second by London Business School executive fellow and former Hermes director David Pitt-Watson.
It found the complexities of retail fund structures, combined with weak fund governance and asymmetries of power between the retail investor and investment manager, have resulted in an “extremely unbalanced” principal-agent relationship.
The panel concluded the widespread and persistent problems of cost opacity and cost control suggest underlying structural deficiencies, and call for a “radical” solution.
It proposes introducing a single and comprehensive investment management charge, which would include estimates of forward costs, such as transaction charges. All other costs, currently deducted by the investment manager directly from the fund, would be reflected in the charge.
It has also suggested investment managers should have a strengthened legal obligation to put the interests of customers first, claiming the FCA’s treating customers fairly principles are not effective enough.
The panel says: “The single charge regime would place investment managers at risk for the decisions they make and strengthen accountability. The reform could trigger a sea-change in industry practices and remuneration structures.
“The panel fully understands that such a radical proposal would require structural changes in the industry and would likely be challenged by investment firms. However, we believe it merits consideration because other options are not working.”
Many argue, however, it is not possible to include forward charges in cost measures.
Investment Management Association chief executive Daniel Godfrey says: “Where I would disagree with the panel is on fund managers charging for transaction costs in advance, because at the beginning of the year a firm has no idea how much trading they are going to do.
“If you include transaction costs in the price then inadvertently you create the ultimate conflict of interest: the job of the fund manager is to trade in the best interests of the customer, but if it is coming out of their profit, there is a conflict.”
King & Wood Mallesons partner Tim Dolan agrees there is the potential for fund managers to be at risk should the costs incurred exceed the annual charge in any one year.
He says: “If the fund manager says the cost will be 3 per cent and it turns out to be more, the firm would have to bear the extra cost.”
It has been suggested fund managers could predict forward costs by taking an average of the past three years.
But Wealth Management Association deputy chief executive John Barrass says: “If you are going to use estimates, you have to be very careful with how you use them and how you explain that to investors. It must be completely clear that this is an estimate.”
The Consumer Panel argues that despite the IMA’s views, other experts have said it is possible to include forward costs in the charge.
The panel has called on the FCA and the Department for Work and Pensions to investigate the issue further, and says it will invite those with opposing views to a roundtable discussion in the new year.
The investment management industry argues it is already doing much to improve disclosure and transparency.
The OCF has been cited as a solution by some, but this does not include entry or exit charges paid directly by investors, interest on borrowing, brokerage charges or dealing costs.
Analysis published by Money Marketing in May also revealed advisers are facing difficulties in obtaining OCFs for funds through some research tools.
Furthermore, managers take an inconsistent approach, with some taking certain charges on to their own balance sheet to offer a lower overall cost.
Chelsea Financial Services managing director Darius McDermott says: “In a world of greater transparency, there must be a simple charge.
Some groups may put all the charges on the fund and will look more expensive. Other groups will put the basic charges to the fund and will take certain charges on their own profit and loss. Some OCFs are well north of 100 basis points and some are just 60 or 70 bps.”
The IMA says it has developed a new measure, which tells consumers in pounds and pence how much a unit in a fund grew over the course of year and how much it cost to achieve that performance. The measure is set to be in place next spring.
Godfrey says: “Pounds and pence disclosure goes beyond any regulatory or legal requirement and is a big step forward for consumer understanding.”
However, he accepts there is a big difference between this backward-looking measure and what the panel is calling for.
He says the industry has “not done a terrible job” in developing the OCF, but conceded this only applies to authorised funds and not pension funds.
True and Fair campaign founder Gina Miller says: “Information given after a consumer has bought something will not enable them to make better decisions. The fact that it is per unit also means consumers will have to do their own calculations to work out the true costs. The IMA is not moving towards full transparency in a simple and understandable way.”
The True and Fair campaign is lobbying for firms to disclose a breakdown to consumers of all fees incurred in the investment of their money.
Miller says: “The Consumer Panel report concludes that every element of the industry is fundamentally flawed. It shows there is no genuine price competition, the cap on pension charges does not work, and regulation has been inadequate.
“This dossier of widespread consumer abuse must not be allowed to be swept under the carpet.”
She argues cultural change will only occur when there is transparency of holdings and costs, and independent members on company boards.
While the calls for reform are getting louder, EU legislation could stand in the way of any meaningful change in the near future.
The Markets and Financial Instruments Directive II was passed into law in February and will require financial firms to report total investment costs to consumers. The rules will be implemented on 1 January 2017 and cover investment managers, discretionary managers, private client wealth managers, platforms and financial advisers. The regulations require the costs to be set out in an understandable format and include all costs that affect investors.
Dolan says: “Under Mifid II there will be an obligation for all costs and charges to be disclosed, as well as the overall cost and cumulative effect on returns.
“I do not think we will see anything as radical as one single charge, but the disclosed costs could include reasonably foreseeable forward costs. The FCA will set out how it will interpret and apply the rules for the UK market next year.”
Dolan argues there should be no major rule changes before 2017, while Barrass agrees two sets of reform would be too expensive for firms to implement.
Barrass says: “We are wary of excess burden on firms. There needs to be a more realistic expectation of timescale, given that we have European legislation coming down the line.”
But Consumer Panel member Teresa Fritz says: “We are behind Mifid II, but there is still work to be done on what is meant by full disclosure. Also, it does not currently cover some areas, such as unit-linked pension funds.
“If we just sit back and rely on Mifid II, all sorts of things could happen between now and 2017 that mean we do not get to where we want to. We have raised the issue early enough for action to be taken before 2017.”
The pension freedoms being introduced in April add to the sense of urgency.
Fritz says: “Post-April, millions more people will go into drawdown or take their money out and invest it elsewhere. Costs and charges are going to be even more crucial for more people, particularly those with medium-sized pots, who will need to get the most they possibly can from those pots and need to be able to establish value for money.”
Another major regulatory development in the coming months is the FCA’s thematic review on investment advice due diligence, currently underway and due to report next year.
Responding to a question from Money Marketing at a conference this week on whether the lack of transparency on fund management costs prevents advisers from carrying out adequate due diligence, FCA technical specialist Rory Percival said: “Clearly it is important for the disclosure of fund management charges to be clear.
“When we met with a number of interested parties in the due diligence space earlier in the year, this was a subject that came up often, with the industry saying they find it challenging to find out this information.”
He noted the FCA is also working on a policy paper on disclosure, due to be published in January.
RGP Compliance managing director Simon Collins says transparency of fund costs is “critical” for advisers’ due diligence.
He says: “I suspect the review will say that despite the difficulties, advisers need to push fund managers, ask more questions and refuse to accept information at face value.
“That is where historically advisers have got themselves into deep water, with products like Arch cru and Keydata. The thematic review needs to bring out exactly where advisers and providers’ responsibilities lie.”
The FSCP’s report will go down in time as a can of petrol on a fire that was already burning. That isn’t to say that it’s unwelcome, or wrong in any way. It is demonstrably true that fund management costs are opaque, poorly understood and loaded against the retail investor in particular.
Our own work, which we’ll publish soon, into multi-asset investing and managed portfolio services for centralised investment propositions bears this out, with knobs on. When those who earn a living analysing and assessing the market can’t find out what’s going on without getting out a pair of tweezers and a headtorch, what hope does Mrs McGlinchey have?
Let’s be clear. This is an industry which can invent investment strategies that get people to believe down is up, bad is good and that managed funds are suitable for anyone. It is stuffed full of clever people, and yet we are meant to believe that coming up with a total charge disclosure figure for the year to come is beyond the wit of man? It’s not. The industry just doesn’t want to do it.
OMGI has proved recently that (within the confines of OCF) you can commit to forward charging disclosure. There’s no reason why that can’t extend to a more complete disclosure.
Of course, fund management companies don’t want to do this, because it’ll make them look more expensive. No-one is going to volunteer to go first, so everyone is going to have to go at the same time. If it takes regulation to do this, that’s a shame, but the half-a-loaf responses of the industry so far probably mean there’s no alternative.
There is no argument against allowing people to understand the cost of what they’re investing in. This isn’t spurious accuracy. It’s stopping what is, in effect, systemic deception. Sunlight remains an awesome disinfectant.
Mark Polson is principal at the Lang Cat
Laith Khalaf, senior analyst, Hargreaves Lansdown
It’s very difficult as the numbers are open to interpretation. Transaction costs are variable so you can see spikes in them, for example when a new manager comes in and changes the portfolio. I agree it is good for investors to know all charges but there is a key difficulty of variable charges.
Scott Gallacher, financial planner, Rowley Turton
I think fund managers’ arguments against transparency are misleading. There will always be a period when costs are higher or lower but you are making those trades to add value to your investor so what’s the issue in disclosing the charges? We have to disclose what we charge our clients.