Active management at the security level is a waste of money and detracts from the decisions that aren’t. That’s the damning message in the FCA’s interim report on asset managers that the media seized on.
But who really should be demonised in that case?
End-consumers who are too weak or too lazy to have worked this out for themselves? Intermediaries who buy this stuff and should know better? Or the product manufacturers, for taking advantage of both weak customers and weak intermediaries?
As the study points out, most product sales or arrangements are intermediated by the likes of IFAs, private-client managers, pension consultants and consulting actuaries. Relatively few end-investors buy products direct (says the FCA) and when they do they are likely to be guided by platforms (some of which, we say, are advisers in all but name). That puts intermediaries firmly in the dock. If there is a market failure it is mainly on the buy side. If it is to change, it will be because of demand shifts occurring within intermediary business models.
The focus of our reaction to the report is therefore on whether each set of intermediaries is changing or reinforcing the way product manufacturers compete. From this perspective, the FCA’s power to influence the change process is not much more than finger pointing.
Asset management as a product-manufacturing model
The study tells us 68% of funds could serve as a single building block in an asset-allocation framework. Given the fact that much of the intermediation identified above works from asset allocation to fund selection, this tells us that the value proposition of the asset-management industry is fundamentally different from that of intermediaries – as different as an architect or builder from a manufacturer of bricks. Whilst there are some mixed funds (probably in multi-asset or absolute-return categories) that can serve as a substitute for a relationship with a single portfolio manager or adviser (providing a building not just building materials), most asset-management products offer a very narrow value proposition defined largely by relative performance in a category. My brick performs better than yours.
In light of this it is important to separate effects on the product market you think are undesirable from effects you ought to expect. It is not obvious from the report that the FCA shares this insight. The old FSA, which was no more fooled than the FCA today by active managers’ finery, was quite realistic about this. As long as the product market competes on performance, it realised it couldn’t expect to see the features associated with an efficient, unrigged market, like price undercutting, commoditisation, concentration. Instead it should expect to see proliferation of new products (even when they are homogenous), fragmentation of suppliers and price clustering. These features should be expected to persist until the basis of competition moves away from performance. It could compete more on price. But even if average fund costs fall, the other features of competition by performance, including proliferation and price clustering, will probably persist.
Focus on intermediaries
This unsatisfactory yet fundamentally rational model does not apply to intermediaries who create the services that make use of asset manager’s products. Their value proposition can be much richer. Peer-group competition can be differentiated by beliefs, by revenue model and by service format. Value can be assessed in terms of soft factors such as ease of decision making, clarity of expectations, or quality of service. It is far too simplistic to see intermediation in terms of the active/passive debate, even if this explains some of the differentiation (like beliefs or charging). Building allocation-driven portfolios, even with use of passive building blocks, necessarily involves manager risk and it takes an active form. There are performance consequences but they do not, and should not, dominate competition between peers.
There are five forms of intermediation that are partly or wholly within the scope of the FCA’s study. These have already made some contribution to changing the demand for product, influencing product manufacturers’ behaviour. In the rest of this article we say how the score card looks for each.
1. LDI managers
Asset strategies driven by liabilities represent by far the most potent shift in manufacturing power and it hasn’t ended yet. Ironically it came about by manufacturers emulating an intermediary function: actuarial consulting. By defining the value of asset management in terms of maximising idiosyncratic client welfare (what variable does a pension fund most want to control, what risks can it take with it?), LDI broke the mould of balanced management and its self-serving single, standard definition of client welfare. Many of LDI’s building blocks do not even require asset managers, relying on liability-hedging securities and derivatives. Though these can be pooled as a product, the basis of competition is quite different from other products. LDI is asking all the right questions. But so far it is largely limited to institutional clients.
LDI merited only a few pages in the FCA report and only from the perspective of being a branch of product manufacturing rather than a force separate from it. Bizarrely, it chose to single out concentration as a possible market negative (though it dismissed it as an actual problem). Bizarrely, because this is what a normal market would look like, with economies of scale trumping proliferation.
2. Fiduciary managers
This is the reverse: consulting actuaries emulating asset managers. It is a strategy driven by envy so not surprisingly all they have done is turn their asset-allocation and manager-selection advisory functions into a multi-manager product that replicates the balanced-management function and so replaces asset managers who previously provided it. The only material difference is that selection decisions are farmed out or spread around, whereas balanced managers typically do it all. Value is only created by that change if consultants are better at selecting active managers than active managers at selecting securities.The FCA in finger-pointing mode wants trustees buying fiduciary management to ask themselves whether they really believe that.
It could conceivably go further and say that fiduciary managers have a fiduciary duty to justify any preference for active management – in other words they must spell out the costs and benefits and explain the theoretical and evidential context, however inconvenient. But why wouldn’t that duty apply to any other type of investment firm which both advises and manages?
Investment consultants to institutional investors are the surprising whipping boys of the FCA’s interim report. Before the final report emerges, the regulator needs to sort out some inconsistencies in its stance here. Consultants perform those two advice functions that fiduciary managers made discretionary: asset allocation advice and manager selection advice. The second means they are reinforcing the competition by performance. Ironically, though, the report also singles out consultants for insufficient accountability for the performance of their asset allocation advice. This makes no sense. If the information value of performance data is limited or non-existent, what is the point of trying to draw asset allocation into the same game? All that will do is reduce customisation and increase standardisation, because that is what participating in the performance race requires. And to the extent the advice is (as it should be) customised to the liabilities of the client (because these are mainly pension or endowment funds), whose performance is it anyway?
It is true that consultants are disappointingly weak agents for change in the asset-management industry and just maybe the FCA’s main message will prompt customers to ask tougher questions about the relevance of all that data analysis consultants love.
Collective investment funds are mainly bought by retail customers and most are intermediated by IFAs. IFAs are largely outside the scope of the FCA’s study, due to an ongoing Treasury-sponsored review of the advice market. This is a pity because the IFA sector is one of the main agents for change in product demand. They are shock troops in the war against waste in product manufacturing. And it’s working. The credit for that goes in no small measure to the FSA’s RDR initiative, whose origins lay in its insight that the commission model was reinforcing a bias to active management. The old model also encouraged clients to focus on the underlying asset managers as the main sources of value instead of the advisers, doing IFAs no favours.
Post-RDR, IFAs have spotted that it’s better to use more of the same customer budget on their value-adding activities and less of it on the firms that manufacture the portfolio building blocks required to implement asset-allocation strategies. So firms who were once philosophically wedded to active management have experienced a Damascus moment and are now enthusiasts of passive funds and outcome-focused products such as target-date funds and products with guarantees.
IFAs are increasingly signalling that there are many sources of value for their service more important than selection skills. One of the big improvements in the IFA service proposition in recent years is surely a greater goal-planning focus, with cash-flow planning tools encouraging the quantification of outcomes and the specification of time horizons. A small minority are even using stochastic projection tools instead of the FCA’s prescribed growth rates. Many describe themselves as liability- or outcome-driven. These advisers have the greatest capacity to move the value proposition away from performance (getting the better of uncertainty) to planning (making an appropriate accommodation with uncertainty).
The FCA report groups new digital asset-gathering models with conventional platforms. Though clearly over-simplistic it is safe in one sense: both revenue models are now driven by the value of assets on the platform. This is another version of business-model envy. To the extent the platform supports portfolio construction at an asset allocation level (even if integrated with the selection of the implementing products), that construction approach replicates the dominant balanced-management format, with portfolios categorised by risk levels and risk defined by short-term nominal return volatility. This is true whether the platform is providing guided selection, regulated advice or discretionary management.
Platform models are not proving to be the drivers of the alternative value propositions coming from the IFA sector except as places those advisers can buy and hold products that do not compete on performance, such as passive funds and target-date funds from the top providers. In fact, platforms are reinforcing the existing product market more than they are changing it, by enabling a growing fashion for ‘models on a platform’. These model portfolios allow IFAs to act as if they were portfolio managers but replicating the standard portfolio approach and its accompanying fixation with manager or fund selection based on performance and rankings.
For platforms to be agents of change they would need to support approaches to portfolio construction that tie in with the advisers’ specification of purpose and time horizon, which is what cash-flow planning leads to – or even provide the same functions direct to consumers. Platforms do not provide information about period-specific probable outcomes that could be used to improve the discovery of clients’ true risk tolerances, or that could be related to economic consequences in a way that would make capacity for loss, or shortfall, more valuable than just measuring volatility-driven paper losses. They are not generally providing the modelling tools that are needed to shift the value proposition onto goal planning and asset allocation. They can’t group holdings by shared goals instead of legal owners and types of account. They can’t report journey progress at the level of a virtual goal-based portfolio. But even if they could, it needs more. They would need to stop pretending that their manager-selection support tools are worth relying on or that they define in any significant way the value of the service. This is not the sort of change platforms will instigate themselves: it needs the users to drive it. It is therefore hardly surprising if platforms merely reflect the product mix observable in the market as a whole.
Roboadvice models, which are really portfolio managers, do clearly have a bias to passive implementation but they are not attracting enough assets to make much of a dent in the overall market product mix. The reason they are not attracting assets is perhaps because they have chosen to replicate online approaches. They have not used technology to redesign the processes themselves.
What can the FCA do?
From this perspective of product intermediation driven by different service formats, what can the FCA do, if anything, to encourage diversity of formats that might weaken attachment to competition by performance? There isn’t another big measure like RDR. So you can see why the FCA wants to talk over the heads of the industry to the public at large (with the help of the media) and hope they are listening. And active management, however simplistic, is the right button to press. There is a band-wagon effect so there are today journalists prepared to say, yes, the FCA is right: active management, like the emperor’s finery, is just a popular delusion.