The UK's Retail Distribution Review has caused turmoil for independent financial advisors (IFAs) and fund managers that is reminiscent of the 'Big Bang' of 1986 in the banking world, but much was already changing before it began. Simon Ellis, the principal of Strategies in Asset Management Ltd., presents Part One of a sweeping panorama of the asset management and advice industry in both its old and new forms.

Once upon a time, the World was flat. There was a natural order of things and everyone knew his place. There were advocates of the Earth being round (indeed, going back to Ancient Greece) but it suited most people in positions of leadership to stick with the 'flat Earth' view. Then came the discovery that the ‘round view’ worked better in practice (we have to blame Columbus and Magellan for this) and the flat-Earthers were slowly subjected to more and more ridicule.

Apocalyptic long-term change

In this article we shall see how the ‘natural order of things’ in retail fund distribution as it applied to the high-net-worth wealth-management market has been turned upside-down because of the RDR but also through pressure from an alternative way of thinking that had been gaining ground for a few years beforehand.

Power in the value chain has now shifted irrevocably from product-providers to distributors/advisor firms, and the battle-lines between them have now been drawn up. The short-term situation is full of noise and confusion and so demands closer examination, but the forces in play now will cause apocalyptic long-term change. The question arises: is the RDR the fund industry’s version of the Big Bang? Have we gone from ‘flat Earth’ to ‘round World?’

The historic value chain that ran through the Nineties and most of the Noughties was effectively controlled by product-providers. The reason is simple: bundled charging. By acting as ‘factors’ for the entire value chain, the providers dictated the prices that the customer paid and distributed the resulting revenues all over that chain.

Although there was room for some negotiation over fees, the capping of total revenues through annual management fees (plus some additional expenses for administration) at a typical 1.50% meant that each participant had to take a share of each fee. The market norm became 75bps to the manager, 25bps to any platform and 50bps to the advisor, regardless of the relative value that each party might be 'adding' on the customer's behalf (1 basis point or bp being 0.01% of the fees that the client pays or, as we are looking at the past, paid).

Competitive behaviour, such as it was, revolved around relative fund performance and star fund managers. Even when the combined total costs of funds-of-funds packages in bps ran into the high 200s, price competition was of little importance.

The Old World value chain

What were the key characteristics of this 'world as we knew it'? Distribution was highly fractured and there were plenty of small advisory firms. Only the clearing banks and a handful of national firms wielded much bargaining power. There existed a limited number of centralised professional fund-buyers, largely in the form of funds-of-funds or private client firms, which meant that all fund companies could hope for support from someone, rather than flows being concentrated into a handful of well-researched ‘mega-funds’ in key sectors.

Passive funds were used occasionally and made up less than 8% of the Investment Management Association (IMA) universe. It was a market dominated by sales and marketing ‘push’ strategies. The fund managers were the kings and the people who could sell a lot of 'product' were at least princes.

As insured products fell in popularity, fund management companies were seen as 'the good guys,' largely in contrast with the insurance companies and banks which were seen as 'the bad guys.' Fund firms, which were numerous, were well-regarded partly because they had done nothing actually evil, partly because they were (allegedly) skilled, and partly because by choosing between assets they injected a measure of objectivity into the market. They had a reputation for probity that lasts in some measure to this day and they were not involved in scandals and frauds.

Notes to Figure 1.

The old-style sales model, prevalent before the RDR, was already breaking down but still recognisable a year or two ago. This is – or rather was – the old 'push' model in transit. The product-providers pushed their products out into the market and a grateful audience ate them up. To put it another way, the PPs decided what was going to go to market, they forced it through the channels on this diagram and clients accepted it because there was nothing else available. If the products were not sufficiently popular they failed, but the whole process was determined by 'push' factors from the suppliers and not the 'pull' factors of demand.

At the bottom of Figure 1 (in the large, amorphous bubble) are the traditional services – custodial services, transfer agency services, fund accounting – that a host of people performed for the asset-manager. To these we can add trusteeship services, performed by a trustee in the case of a unit trust and by an ACD or authorised corporate director in the case of an OEIC (open-ended investment company). The transfer agency looked after the register which said who owned this-or-that unit. It registered any change that happened, e.g. someone receiving a dividend, someone putting money in or someone taking it out.

Fund accounting was normally the province of a third-party administrator but sometimes the fund management company performed that service in-house. The providers of these services typically charged their recipient, the fund management firm, the total expense ratio – a calculation that added the annual management charge (AMC) to the additional expenses as seen in the Report and Accounts. The Financial Conduct Authority is now thinking of cutting fees for this sector, or at least insisting on greater clarity regarding the roles of the various participants.

The asset-manager then provided services to the next stage in the value chain – the fund – and more or less determined its own price for it along the way. Its charges stemmed largely from a 'going rate' that the market set and typically totalled 150 bps. Competition was simply not a factor in the setting of this charge; market comparison operated here rather than market forces.

The fund's income – which came from the client paying it an AMC of 150 bps – is invisible on this chart.

The platform acted as the collecting agent of fees from many fund groups (though there is only one on the chart) for the independent financial advisor (IFA). It was also the 'aggregator' of deals – if a high-net-worth customer told his advisor that he wanted to buy five funds, the platform would do it through EMX, the electronic fund messaging system. The sales typically passed through 75 bps, of which the platform kept 25 and the IFA kept 50. The fund paid the platform its commission, which was known as a rebate.

The platform, in turn, was basically an aggregated dealing service. It provided a single point of valuation for the distributor group, to which it passed a commission onwards. The distributor group was solely there to collect IFA fees. An IFA and its distributor group were the same thing monetarily but many IFAs usually sheltered under one distributor group. St James' Place is one example of such a group. Others are Sesame Bankhall, Simply Finance, Intrinsic, 360, True Potential and Positive Solutions.

Lastly we come to the advisor, whom the distributor group hosted. The advisor was really at the wrong end of the chain. He sometimes worked on the client to push him into buying this-or-that product or fund in accordance with his own interests and nobody else's. Many supposed IFAs were really tied agents.

All change!

This all seemed to work well, at least for some, yet the strains were already showing by 2011. Some advisors were moving to holistic planning and charging fees for services to clients outside the 50bps trail fee (the continuing commission payment but not the initial commission payment or introduction payment) approach we mentioned earlier. Most importantly, fund supermarkets and wrap platforms had emerged to separate ('disintermediate') fund managers from distributors and clients and to challenge the mechanism of control over revenue streams that had been wrapped up in the AMC-based model. 'Disintermediation' was a massive change: on the old model, when someone dealt with a fund company their name went onto its records, whereas nowadays the fund just deals with a platform without knowing who they are.

A growing handful of key distributors also managed to press for and secure ‘special terms’ in the form of additional private rebates, a practice that had previously been limited to a couple of life companies or certain mass distribution agreements. Were fund managers already losing control of the value chain?

Underlying trends were eroding the old world model, but the credit crunch of 2008 and poor investment returns were also undermining confidence in fund management. Fund managers were slipping from their place as ‘good guys’ and acquiring a reputation for being part of the problem. The RDR and the advent of full transparency coincided to break the old model forever. Membership of the old Flat Earth Society was about to become a drawback.

The second chapter of this two-part article will contain a diagram of the investment management world as it is now.

Simon Ellis

Principal

Strategies in Asset Management Ltd.

simon.ellis06@ntlworld.com