FCA to make funds state their value for money

The new rules are the result of the FCA's two-year-long Asset Management Market Study, the final report of which was published in June last year. It found that fund charges were not always visible to private investors and, even when they were, investors did not pay enough attention to them or understand the impact of them on investment returns. The report concluded that as a result of this many investors are holding products that are poor value for money.

The FCA's interim report published in November 2016 reported that £109bn managed by the £6.9 trillion UK asset management industry was in "expensive active funds that closely mirror the performance of the market", so-called closet trackers. And it said around £6bn was invested in passive funds that are significantly more expensive than average. 

From 2019 asset managers will have to provide an 'assessment of value' statement that demonstrates the value of their products to investors by assessing their quality of service, performance, internal costs and economies of scale, including whether a fund can achieve savings or benefits through its size. Asset managers will also need to consider comparable market rates for any service provided by the fund, or to the fund, and whether it is appropriate to keep fund investors in share classes with higher charges.

Hugues Gillibert, chief executive officer of research company Fitz Partners, says this will be complicated because asset managers will have to conduct a detailed review of several layers of services provided to their funds. But the FCA's focus on market rates will increase the pressure for more competition within the industry because even if a provider finds that its fund delivers value for money, its costs will need to be benchmarked against similar products.   

Shaun Port, chief investment officer at online wealth manager Nutmeg, says the key to whether the new measure succeeds in increasing value for investors is how it will be implemented.

"It's going to be quite hard to tie down what value means as every asset manager will say its funds are great, so I hope the regulator pushes for best practice [on what funds need to show]," he says. "What we want to see is more transparency on how costs impact a portfolio and detailed analysis on how charges affect a fund's performance, presented in a user-friendly way."

But although asset managers will have to consider their funds' economies of scale in the assessment of value statement, they will not have to reduce investor fees on account of size. This is despite a larger investor base meaning that the amount each investor needs to contribute to cover a fund's fixed costs is reduced.

"Asset managers can choose to reinvest savings achieved via economies of scale into the business and/or subsidise other parts of the business," explains Mike Barrett, consulting director at platform research company the lang cat. "However they will need to demonstrate how this is in the best interests of investors."

The FCA will also require asset managers to appoint at least two independent directors who will represent at least 25 per cent of their boards. And under a prescribed responsibility requirement an individual senior manager will be responsible for ensuring an asset management firm produces its annual value assessment, recruits independent directors and acts in the best interests of fund investors.

The FCA has also made it easier for asset managers to move fund investors into cheaper share classes. Previously asset managers needed consent from an investor to do this, but now they only need to give investors 60 days' notice before moving them into cheaper share classes, as the move is in investors' best interests, says the FCA.

Fitz Partners recently found that 34 per cent of retail assets invested in UK funds are still held in legacy share classes that pay rebates to financial advisers. This has fallen from over 70 per cent in 2013, when the retail distribution review (RDR), which removed this practice, was introduced. Fitz Partners says the overall average saving on fund fees for investors moving from a legacy retail share class to a 'clean' one that doesn't pay rebates to advisers is 0.55 per cent.

Average ongoing charge for clean share classes of active and passive funds

Source: Fitz Partners as at 09/04/18

The FCA will also not allow asset managers to benefit from risk-free 'box profits' from 1 April 2019. These are profits that managers of dual-priced funds can make by dealing as principal in the units of their funds. Single-priced fund units have one price, but dual-priced fund units have different buying and selling prices with the difference between them called the bid/offer spread.

Christopher Traulsen, director of fund research, Europe and Asia at data provider Morningstar, says: "Asset managers are often able to [match] buy and sell requests against each other so that no trading is required to fill these orders, meaning no costs are incurred. But they still collect the spread and pocket it as profit."

Mr Port says a change in behaviour by the asset management industry is long overdue. "The FCA should be prepared to take action on any firms dragging their feet," he says.

Gina Miller, founding partner of wealth manager SCM Direct, says: "It is shocking how long it has taken the FCA to achieve nothing more than restating the obvious. They have dealt with important but relatively minor negative industry malpractices, such as box profits, but not the substantive issue of misleading fees through the various distribution channels."

Mr Barrett thinks that the rule changes will improve things, but adds: "[The interim report in November 2016] highlighted how much money was in expensive passives and closet trackers, which investors would be better moving out of, but nothing has really been done about that. The regulator's enforcement activity around closet trackers is working its way through, but of around £109bn in closet tracker products, only £34m has been paid back in compensation to investors. It’s good the asset management industry is being told to take more personal responsibility and hopefully it will have the desired effect, but in the interim investors will be stuck in these poor value funds."

Benchmarking and performance

The FCA is also consulting on how to make fund objectives more useful to investors, and asking for feedback on how funds should explain their use of benchmarks to investors. The measures it proposes include:

• a requirement to explain, so that authorised fund managers explain their decisions about the use of benchmarks. Or if no benchmarks are used, an explanation of how fund investors should assess a fund's performance.
• Requiring authorised fund managers to be consistent in their references to benchmarks in their interactions with fund investors.
• Where authorised fund managers show a fund's past performance in disclosures they must show it against any benchmarks used as a target for the fund’s performance or that act as a constraint on the fund’s portfolio construction.

The consultation also proposes a rule preventing asset managers from levying performance fees on the basis of a fund's gross performance - ie performance before other charges such as the management fee are subtracted. 

To respond to the consultation email: cp18-09@fca.org.uk by 5 July 2018.

Protect yourself from poor value funds

The FCA favours quoting an all-in fee for asset management services expressed in pounds and pence, so it is clear and simple to understand. Regulation that came into force this year called Mifid II and PRIIPs requires that investors see the full costs and charges expressed as a single fee for most transactions in investment products, on an ongoing basis. This information should be on asset managers' websites, although can be hard to find.

When assessing a fund's value look at its management fee, transaction costs and any performance fee, and compare them with other funds of a similar mandate and size. It is important to do this because charges are a drag on performance and, due to compounding, even a small difference can have a big impact over time. For example, the lang cat calculates that £100,000 invested over 30 years, growing at an average of 6 per cent a year, would total £432,194 if total fees equalled 1 per cent. But with total fees of 2 per cent this would only grow to £324,340.

Impact of charges in £ on £100,000 investment assuming 6% annual growth

Source: the lang cat

Impact of charges in % on £100,000 investment assuming 6% annual growth

Source: the lang cat

And while some investors put money into funds with higher charges in the hope of higher returns, the FCA's asset management study found no clear relationship between charges and gross performance for active retail funds in the UK. Rather, it found some evidence of a negative relationship once charges are taken into account. "This suggests that when choosing between active funds investors paying higher prices for funds, on average, do not necessarily achieve better net returns," says an FCA paper on how best to encourage investors to pay attention to costs.

You can try to avoid investing in a closet tracker, meanwhile, by checking a fund's active share figure – a measure of how different a fund's holdings are to an index. The higher the percentage, the more the fund differs from the index. 

Also make sure that funds with a level of fees consistent with active management do not consistently underperform their benchmarks for several years. See 'How to avoid investing in a closet tracker' on our website or in the Investors Chronicle of 16 March 2018 for more details.