In November Compliance Matters reviewed the British Financial Conduct Authority's first report on competition in the asset management sector. A follow-up report has now arrived which states that the regulator does not (contrary to some popular opinion) favour passive funds over active. It seems, however, that its reforms will favour passive funds in the end.

The FCA refers to today's document as its 'final report' on the asset management market. Among the regulator's 'final findings' are weak price competition in a number of areas of the UK's asset management industry. There is considerable price clustering (cartel-like pricing) on the asset management charge for retail funds and active charges have remained broadly stable over the last 10 years. Price competition exists for some asset management products, but in its non-commital way the FCA thinks that this is "likely to be limited" in the case of active funds, with asset managers competing over other factors. On the subject of passive funds competing more and more with traditional active ones, the FCA has not seen enough evidence to prove that competition from the former is putting pressure on the latter.

The FCA has other positive things to say about active fund management: "We agree that active management plays an important role in accurately pricing assets in a well-functioning market [which] in turn allows both equity and debt capital to be efficiently allocated to the firms that would generate the greatest economic returns to society. Active management can also affect firm behaviour by exercising shareholder rights. We also recognise that passive styles seek to replicate the returns of the market index as opposed to stock picking and therefore do not contribute to the accurate pricing of assets by construction."

The FCA notes that think-tanks and interest groups generally think that price competition is weak in active asset management, while the firms that do it and "a trade body" (presumably their own trade body, the Wealth Management Association) suggest that investors are able to assess value for money, respond to prices, and switch funds.

Price clustering

The report mentions price clustering a good deal in the context of price competition. It concedes that, in and of themselves, price clustering and broadly stable prices do not necessarily mean that prices are above their competitive level. However, it believed in its last report and believes now that price clustering, when combined with its understanding of how firms set prices, the profitability analysis, and the absence of relationship to performance, demonstrates the fact that price competition is weak for actively managed products. It adds: "We have identified issues in both retail and institutional intermediaries and believe further work is merited."

The regulator has found evidence of price clustering for active funds for sale in the UK. Prices paid by institutional investors in segregated mandates are often discounted and so there is less price clustering there than with retail funds that deal with HNWs.

Price clustering: further analysis

The last report analysed price clustering using many funds' annual management charge (AMC) and ongoing charges figure (OCF, an overall total annual charge for owning part of a fund which includes the transaction charges for the buying and selling of investments, designed to provide the most accurate measure of what it costs investors to invest in a fund). It said that, while the price clustering was more pronounced when it looked at the AMC, there still appeared to be certain price points for the OCF. This, it thought, stemmed from the fact that the OCF contains charges levied on behalf of third parties.

Since that report, the regulator has done further analysis of the relationship between the OCF of retail active funds in the UK and the performance generated, both gross and net of fees.

For the three equity categories it analysed, it found that the majority of funds cluster inside a narrow price range but often enjoy very different levels of return. Although it found some variation between prices, the majority of results showed no statistically significant correlation between price and performance.

The weight of evidence therefore suggests that there has been no clear relationship between the gross performance of retail active equity funds in the UK and the level of OCF in the period that the regulator examined. It did find some evidence that more expensive active funds underperformed cheaper active funds when considered net of fees.

Proposals for AFMs

The regulator is thinking of strengthening the duty for asset managers to act in the best interests of investors in one or more of the following ways.

• Keep existing governance structures but clarify their duties, with the regulator perhaps expecting the board of the AFM (authorised fund manager) in question to demonstrate the ways in which it has complied with a strengthened duty to act in investors’ best interests.
• Burden the senior managers of the AFM with more duties by extending the Senior Managers and Certification Regime (SM&CR) to some of them. The regulator is thinking of requiring them to consider "value for money" as part of this new regime’s introduction.
• Change the composition of existing governance bodies to create more 'independence,' perhaps by telling the existing AFM board structure to have a majority of independent members and an independent chairman.
• Create an additional governance body. The regulator might want fund firms to model this on the independent governance committees (IGCs) that preside over direct-contribution pension funds. It thinks that such a body might carry out the new duties, leaving the existing AFM board with its current responsibilities. The regulator is threatening to enforce the new body’s obligations by extending the SM&CR to its members.
• Replace existing governance structures with a new body. Here the regulator is thinking of majority independent fund boards, similar to the US mutual fund structure, with their responsibilities underpinned by the SM&CR.
• More onerous duties for trustees and depositaries, forcing them to assess whether the fund manager is, in the FCA's words, "delivering value for money." This alternative approach would leave current AFM governance structures unchanged.

The single, all-in fee and VFM

The regulator continues to want to oblige each asset management firm to disclose a single all-in fee to each investor, noting that MiFID II will introduce this for investors using intermediaries. The single fee, it hopes, will include the asset management charge and an estimate of transaction charges. The FCA is looking at ways to improve the effectiveness of such disclosures and will consult the public about its proposals, if any, later in the year.

The regulator is worried about AFMs of absolute return funds charging performance fees when returns are lower than their funds' most ambitious performance targets. This leads to the managers being rewarded despite not achieving what the investors consider to be the target performance.

The market study mentions the phrase "value for money" 41 times, yet the FCA does not say what it means by this phrase, even though it is determined to guarantee it to investors. It comes the nearest to an explanation when it reminisces about comments from practitioners and looks at suggestions thrown up by its own research.

"Many respondents noted that value for money cannot simply be measured by net returns against a benchmark. They said it must also take account of a range of other factors such as volatility, stewardship, and whether a product meets specific liabilities or objectives.

"We accept that no single measure of value for money will capture the circumstances of every retail and institutional investor. Overall, the research presented in the interim report suggests that the most likely single measure of value for money from an individual investor perspective is a form of risk-adjusted net return."

An increase in the regulatory burden

Compliance Matters spoke to Marina Cremonese, a London-based vice president at Moody's, the credit rating agency. She stressed the importance of the report.

"This is a big shake-up of the industry. Although this report is important, the first report in November was the big development. The regulators have continued along the same lines as before and have aligned this report with their initial conclusions and they are likely to go ahead with their initial remedies.

"Essentially, they want to increase price competitiveness in the industry. It's much more far-reaching than the Retail Distribution Review because it will affect the whole industry from top to bottom. They are going farther than any other regulator in Europe, and their greatest innovation is their "value for money" concept. We have not yet arrived at the stage of new rules, although they are consulting the industry about that. It would seem that we're going to an "all-in-fee" structure. The object is that everybody should get the right product according to their risk profile and at the right price."

Passive funds, regulatory burdens and consolidation

Ms Cremonese also thought that the future belonged to passive funds and that FCA policy was going to push the market farther and faster in this direction: "When people are being made aware of what they pay, they do not want to pay too much! This is why they will favour passive funds more and more. Passive funds charge considerably less than active funds - a trend that is increasing - and their fees are more transparent. Active funds have to pay more for research, analysis and strategy. In an FCA sample, the regulator found that the AMC for active funds stood at 88 basis points, while for passive funds it stood at only 33.

"Asset managers present fund fees and fund performance in different ways, so there's a lack of consistency in the way it's presented to the end-user.

"I think this market study will make the share of passive funds in the market grow. It will also push some of the active funds' fees down. In the US, the evolution of the fund market towards passive funds (whether they are index funds or exchange-traded funds) is more advanced than in Europe, showing us that there is more room for passive funds to grow here. The FCA's initiative will also lead to higher operational and compliance costs all round, so in a sense the whole industry will suffer. It's a shrinking cake. Asset managers will see their fees go down and their costs go up."

Compliance Matters asked whether ever-more onerous regulation was causing fund firms to consolidate. The answer was yes. Economies of scale are becoming a greater necessity for companies competing in this space. Increasing regulatory costs, competitive pressures on management fees and outflows from actively managed funds into passive vehicles are bound to prompt further consolidation. Ms Cremonese pointed out that Henderson Global Investors (listed in the UK) has merged with its rival Janus Capital (based in the US) earlier this year. Also in Europe and for the same reasons, Standard Life is merging with Aberdeen and Amundi (a French player) is taking over Pioneer (from Italy).

"We have a negative outlook for the industry. It has grown substantially in recent years and was a lightly regulated industry, but no longer. The industry, which has about US$70 trillion in AuM worldwide, is now facing MiFID II in Europe and the Department of Labour's Fiduciary Rule in the US. Regulatory pressure is going up."

The FCA has promised to chair a working group to consider how to make its objectives clearer and more useful for investors before considering any subsequent changes in its rules.