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 Two of his 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. Have we gone from ‘flat Earth’ to ‘round World?’

Notes to Figure 2. The most obvious shape on the board is the giant bubble on the right, which is larger than all the others because of its importance. It represents the fusion of the interests of the private client, his advisor, and the distribution group. They are acting as one, with the advisor wrapping himself around the client and the distribution group wrapping itself around the advisor and the client. Together, they are the movers and shakers of the new 'pull' model, acting as one customer, taking everything from everywhere else. They have a 'single customer view'. This is the result that the Financial Conduct Authority consciously wanted when it embarked on the RDR.

Distribution groups include the large banks and building societies, Skipton Financial Services, Towry Law (or Towry as it is now), AWD Chase de Vere and others. They want to show their customers (and indeed the IFAs) that what they have is better thought-out than rival offerings. They have to show that they are segmenting their clients into different areas and thereby catering to their needs in a more subtle way than previously. By doing so they are forcing advisers to abandon the one-size-fits-all approach and abandon the full-bundled, out-of-the-box type of package that they are used to offering their clients. They have more power over the IFAs because of the new shape of the market and the expectation that those IFAs will, in their turn, be segmenting their client base to a greater degree. The direction of travel is clear and there is no turning back.

The benefit of foresight

St James' Place and Towry Law always followed business models that were similar to the 'three-headed beast' in appearance. Their policy, long before the RDR, was to wrap themselves around the client and look after him. They also kept the advisors inside their organisations – St James' Place called them 'partners' and Towry Law called them 'employees'. These two firms are now prospering mightily because of their foresight.

Towry is slightly more of a model for this new structure than St James' Place, as that latter firm still pays its advisors commissions. Ashcourt Rowan, an old wealth management company and stockbroking firm, has been treading the same path. Its new CEO, Jonathan Polin, has reshaped it to look exactly like the diagram. Another firm called Openwork, owned by Zurich, is travelling in the same direction. Other, smaller firms are paying attention to this kind of structure.

Software providers and discretionary fund managers

Let us look first at the two little circles next to the 'three-headed dragon'. The software providers to its right offer services to advisers. The services they offer are numerous – portfolio planning, para-planning, accounting software, tax planning software (Sage is in there somewhere), inheritance tax software, web portals, possibly corporate tax and payroll for clients that need it, point-of-sale software and compliance software to name but a few. In the old days, the IFA used to go to such firms as TransAct, Still Life or Nucleus Software and asked them to provide him/it with an all-in-one, fully 'bundled' IT package for a platform. In the days when the IFA was normally in the driving seat, the software therefore tended to come from only one provider. Various firms in the market are still trying to do this.

When this way of doing things was prevalent, many unscrupulous software firms took the opportunity to bolt unnecessary services onto their packages and charge extra for them. The RDR hastened the 'unbundling' process but it was already happening beforehand. Other IT firms were already stepping in to prise the existing firms' oligopoly apart. Software in this area is better – and arguably cheaper – than it was before.

The discretionary fund managers run portfolios on the platforms, normally by giving them instructions about what to hold and in what proportions in model portfolios. Advisors appoint the DFMs to run portfolios for their clients, the assets are held on the platform and the DFMs tell the platforms how to allocate those assets. The platforms then send reports to the DFMs on the progress of the models.

Para-planning for the future

A para-planner, incidentally, is a person who works with a financial planner or financial advisor and completes some of the non-client-facing tasks involved in preparing and administering a financial plan or report for a client. About a decade ago para-planners did not exist. Advisors tended to complete everything in the planning process and sometimes (but not usually) processed applications as well, before realising that they could outsource these jobs. The people who filled this role were (i) ex-advisors who wanted to be 'back-room boys' and to avoid having to ingratiate themselves with customers; and (ii) third-party administrators (mentioned already) who wanted to move on and be more active without making the full transition to being advisers.

Para-planners have their own website – theparaplanner.com – that breaks the common description of a para-planner into three types: “an administrator (we are much more than that); an adviser’s secretary/PA (we should be equal to the adviser); and a highly technical and qualified individual who can offer skills in addition to those of the adviser to provide the client with a positive professional experience.” This group might merit a small bubble of their own on the chart, very near the large one.

The intermediary's intermediary

We then move on to the platforms, which play a central role but do not control anything. All the big life offices have entered this area in the last three years: Standard Life, Axa Elevate, Agon, Aviva and Zurich to name but a few. They joined Cofunds (owned by Legal & General), FundsNetwork (owned by Fidelity), Scandia (owned by Old Mutual Global), and Transact, Nucleus and Ascentric. The 'triple-headed monster' of client, advisor and distribution groups asks the platforms for things from the manufacturers, namely the two easterly cogs on the chart, the asset-managers and the fund administration partners. It suggests things for them as well, acting as 'the intermediary's intermediary.' At the behest of the three-headed group, it also provides the client with services.

Come and buy my toys!

There is something of a space-race going on between platforms as regards 'functionality' – they are continually competing to make themselves appear to be performing their services more quickly, more cheaply, promising to improve the websites of others in the supply chain, providing training seminars to IFAs, proffering planning tools. Their only real role is as an online administration service, with a single point of contact for the investment market. They are always offering IT products that the manufacturers would never bother with. The clients, advisors and distribution groups are constantly asking themselves whether this-or-that set of platform services is worth the basis-points that it is taking out of the customer's portfolio.

This is one of the big parts of the market that have yet to settle down. The fund managers (in the circle on the bottom right) have already had their bubble deflated and their profits eroded. The platforms are the next group to feel the pinch now that a new era has begun where all costs have to be out in the open by law.

The manufacturers – the next battlefield?

We now move to the two cogs on the left of the platforms – the manufacturers. The asset-manager's role – that of a financial services company, usually an investment bank, that manages the client's investments, remains the same. Threadneedle, Schroders, Investec, M&G and Fidelity are all players here. They have, of course, had to update their product literature to comply with the RDR, amend distribution agreements to contain new remuneration terms and update their compliance systems generally, so even this relatively untouched cog in the system has had to pay.

The next candidates for a good squeezing after the platforms, however, are the fund administration partners. These are the third-party administrators that we saw in the lower bubble in Figure 1, which maps out the old model of market. In the 'new model' scheme of things they are the upper cog in the manufacturing area. FAPs have a purely transactional relationship with the platforms as agents of the fund managers. A company needs a good deal of capital to enter this space and the margins are tight. Bravura, RBC, BNY Mellon, and the biggest – IFDS – are all here. Things are fairly competitive already and margins are about to tighten yet further.

There is quite a lot of duplication in the new model market for the market to sort out. Many platforms run registers, while every transfer agent also runs a register – why should the client pay for both? The third-party administrators did many things for the fund managers and the distribution companies that the platforms do now. Now that 80% of business goes through the platforms, they now provide these things for 'legacy businesses'. The platforms are now asking why anyone should bother setting up a third-party administrator, although people are still doing it all the time. The overlap of services between the platforms and third-party administrators is therefore bound to lead to 'consolidation.'

The question of questions

In this model, then, each adviser has increasingly to ask himself: “Who adds what value to my customer, and what is that piece of value worth?” Platforms have become the central interface between the demand side and the supply side, with other service providers outside the core arrangement trying to add value to the distributor business itself in the form of, for example, assistance with software or the management of portfolios. ‘Pull’ rather than ‘push’ factors increasingly determine who and what will be used or needed.

What the RDR has done to fees

This is an unfamiliar position for the vast majority of advisers. While they are adapting, all the other parties are seeking to stake their claims for shares of the fees. Without a cap on fees in the form of an AMC, each party can decide what it thinks it is worth. In this world, additional expenses have become more conspicuous and therefore more easier to prune away. In the old days, if the average additional expense was 12bps, it did not stand out proud against an annual management charge of 150bps and might have been considered immaterial. In today's world, however, when it is 12bps on top of 75bps, it is material. As the pie shrinks, 'shrapnel' costs look larger.

The FCA is likely to claim that the apparent halving of fund management fees that the typical customer must pay, from 1.50 % to 0.75%, in the open market is a major and immediate victory for the RDR. This is to neglect the fact that a host of other fees are now being charged that will take average total costs of ownership up to a figure closer to 2.30%. (If you add average levels of additional expenses, platform fees, portfolio management and adviser fees to the investment charge of 75bps the total is actually 237bps!) The flat-Earthers may claim that their weltschauung is simpler and better, but their time has gone.

Clean and super-clean share classes

Are these total costs sustainable in a volatile market where returns are low? The market’s immediate answer has been to say 'no' and to focus on the costs of investment, either by switching more to passive funds, or by attempting to squeeze active fund managers on fees. The move to ‘clean fees’ is a simple transition to unbundling, stripping away platform and trail fees and leaving the net figure available to all intermediaries. However, for previously ‘preferred distributors’ this is in fact an increase in their net fees, and they are not happy. Understandably they wonder why the terms they had before, recognising superior volumes and overall efficiency, cannot be replicated through the creation of new ‘super-clean’ share classes. This is where transparency is 'the killer app.' If everyone can see that a manager can sell a fund for less to some people, why not all? Or, as some are saying, “Why not at least me?”

As this share class debate rages, other service providers cannot afford to be too sanguine. Platform models have fees that range from 10 to 45 bps, but how many of the bundled services do clients or advisers truly want? Why are there so few transaction-based fee models, similar to the US example, where costs are closer to 10bps?

And those additional expenses? Looking across the industry, we find that these range generally from 4 to 20bps, but why the variety between providers? And don’t some of those services behind the scenes duplicate those provided by platforms? In the new world, the median of 12bps looks a lot when amcs are just 75bps.  A distributor will be wondering what is the value of all these mouths to feed relative to the value of financial planning?

Additional fees in the spotlight

As we emerge, blinking, into the ‘World that is round,’ what will happen next? The fund fee debate will probably resolve itself sometime in the New Year. Additional fees, however, are already coming into regulatory focus; a letter has recently been issued and 'visits of understanding' are being paid to eleven fund firms around about now. This looks and feels like a thematic review in the making.

On top of that, total expense ratios have become a competitive issue, with some providers ‘crying foul’ and pointing at firms with large funds whose expenses are high but whose economies of scale are not evident. Some providers also 'cry foul' when there is no obvious link between the total expense ratio and the simplicity or complexity of the underlying asset class. The advent of full 'transparency' – the openness of everyone's finances to scrutiny that would have happened irrespective of what the regulators did – has broken the old mould forever.

Through a crystal ball darkly

Dare one predict the future? From 6 April 2014 onwards, fees for investment and platform services will be charged separately. From April 2016 onwards there will be no more trail commission, although Fidelity Funds Network has told advisors that it will not be switching it off before the deadline. Standard Life is planning to place all its customers in 'clean' share classes by January and has already started to convert assets in bulk. Novia, the wrap platform, is about to start doing this as well. It is unlikely that the market will settle into its final form until the these regulatory timetables play themselves out. However, it is not unreasonable to expect total costs to fall into a range closer to 180-200bps, with all parties except advisers 'taking a hit.'

Despite the avowed intent of fund managers to resist a proliferation of share classes in the UK, it is already happening. We should not be surprised, therefore, to see multiple share classes stretching to include individual classes that are specific to distributors. The 'super-clean' share class seems likely to move to 65bps for active funds, with the very real threat that this will become the new norm for 'clean' shares too. 'Differentiation' may then have to move to being more service than price-based. We must not be surprised to see a very few deals at or near 50bps, or moves to segregated mandates where underlying fees are less obvious for the same capability. On top of this, additional expenses will probably fall into a tighter range (3-8bps?) with the possibility that a single unitary fee, i.e. a composite of investment and administration costs, is seen as clearer and fairer for all.

We should also expect to see a fund industry version of 'the squeezed middle,' with platform fees falling as distributors unbundle platform services, and as clients question ad valorem fees over cost per transaction plus a base fee. Potential new entrants are already eyeing the funds under administration in this sector and running their slide-rules over the possibility of using their strong balance sheets to break the model. Shall we see platforms and the extended chain of 'admin' businesses (custody, depositary, transfer agency, fund accounting etc.) starting to eat each other?

The Big Bang

It is a rare man or woman who predicts what will happen with any certainty, but there can be no doubt that the Flat Earth Society of Investment Management now has very few members. Just as the  Big Bang brought about a major transformation in investment banking and broking in 1986, there is every possibility that we shall look back at 2013 as the seminal year for the retail fund industry. It’s a brave new round World!

Simon Ellis
Principal
Strategies in Asset Management Ltd.
simon.ellis06@ntlworld.com