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VAT of the land

Inscape&#39s recent legal victory over Customs & Excise has established level ground between in-house fund managers and those adopting a manager of managers approach.

Over time, this is likely to have significant implications for the UK fund management industry.

The case centred on the application and interpretation of European Union law which states that the management of special investment funds, which include unit trusts and open-ended investment companies in the UK, is exempt from VAT.

But what is “management”? If the authorised corporate director of an Oeic elects to appoint external fund managers, are the fees and charges they make exempt? We contended that they should be.

Our legal argument was broadly as follows. Inscape&#39s Oeic funds are by regulation widely diversified across different asset classes and markets. To meet investors&#39 expectations requires a wide range of skills which are beyond the scope of an individual manager and necessitates the use of specialists in different markets. By hiring external managers to meet these needs, they add an extra link to the chain of exemption from VAT but do not break it.

We also argued that the UK authorities had taken a narrow interpretation of the rules and one which was not intended by EU law. To back this up, we produced an examination of the original legislation which showed that in key passages it had been partially misinterpreted when translated into English.

Following Customs & Excise&#39s recent decision to withdraw their appeal, now is a good time to consider the broader impact of this case on the industry.

In recent years, the manager of managers approach has been adopted by a growing number of UK-based investment management companies but still only has a minor share of the market. As a result of this VAT ruling, the pace of growth is likely to accelerate.

Dissatisfaction with the shortcomings of traditional fund management has been growing. Too many investment houses have inconsistent performance records which show a poor trade-off between risk and return. The resulting lottery is made worse by fund managers frequently changing jobs, which makes a full analysis of style or even ability very difficult.

Some houses have tried to introduce clarity by adopting a particular style, most commonly value or growth. But styles move in and out of favour along with their ability to deliver relative outperformance.

This has in part spurred the growth of indexation and other quantitative styles of fund management, which seek to avoid the volatility and disappointments which strong style biases can bring.

The manager of managers approach provides a more satisfactory solution. Where practised within a rigorous selection framework, it can give investors access to the core competencies of the best teams within the best investment management companies – the elusive centres of excellence with the ability to consistently beat averages. These can then be used in combination to provide portfolios of choice, not compromise.

This has some very important implications for invest-ment management companies. As the manager of managers approach grows in popularity, new business flows will become more concentrated, with the focus not simply on the best fund management companies but on the areas within fund management companies that truly excel.

To a degree, non UK-based talent will benefit as, free from the restriction of having to invest in existing UK funds, managers who take a direct contract approach look to select the best on offer.

Pricing power for the strong will continue and may improve but for the rest, margins must fall, with index trackers guiding the market price for average performance. A number of big institutions, many with powerful distribution, contract with internal managers on a cost of supply basis. Changing market pricing dynamics will increasingly bring this into question.

An improvement in quality and, importantly, a reduction in the volatility and even randomness of returns will lead to a push for greater predictability. Managers will provide this by benchmarking products and giving them explicit returns and risk targets. Advisers will then be able to assemble portfolios designed to meet the needs of their clients in an efficient and credible way.

Manager of managers is a rational but not cheap app-roach to fund management. Research costs are high because of the need to monitor a big number of managers in a variety of locations worldwide in detail.

Blending managers into portfolios requires an ability to model risk in a sophisticated way and neither the equipment nor individuals that provide this facility are cheap.

As ever, therefore, there are barriers to entry but more entrants will follow Inscape into the manager of manager sector, convinced by the merits and no longer disincentivised by a VAT-imposed financial penalty.


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