Can a regulator create competition? Entering the second year of the Financial Conduct Authority’s ambitious Assessment of Value project, many are unconvinced. The new process aimed to energise a UK mutual funds industry that the FCA deemed not to be delivering for investors. Non-executive directors were to lead this change, delivering meaningful challenge internally within management groups and reporting publicly on product governance. It was a tough ask, and if the industry is moving at all, it is painfully slow.
Even with continually underperforming funds, conclusions in reports tend to be “continue to monitor” rather than taking corrective action. And some of these supposedly public statements are much easier to find than others – a few groups have taken the option to bury the result in the middle of a lengthy annual report. A review by Fund Boards Council, an organisation promoting fund governance, found very few examples of managers making a clear effort to take remedial action. For some companies the challenge may be seen simply as a regulatory burden to be dealt with by a tick box approach. Only a few seem to have been encouraged by the findings of their assessment to re-shape investment policy.
The FCA sought investor-friendly reports, based on seven specified criteria, with scope for directors to add additional factors. Within principles-based regulation the onus is on those reporting to look beyond the letter of the guidance and capture its spirit. Rather than simply value for money, the aim was to encourage a more holistic view on overall value. But with no standard template, reports have ranged in length from 2 pages to over 150, with a multitude of different approaches to value. Even in the simplest language, retail investors and advisers will struggle.
The industry itself questioned what problem the new approach was trying to fix. Certainly it is not perfect but running mutual funds is heavily regulated. Regulation on conflicts and Treating Customers Fairly should have addressed these issues, and there is already a wide range of other formulaic investor disclosures on performance, cost and risk. The exercise seems more about removing outliers than changing the basis of competition in the industry. Customers can choose from hundreds of funds, almost 200 managers and many advisers and platforms. An avalanche of new, non-comparable data may be seen by investors as a burden rather than a solution. There is little sign that underlying investors escape the impact of rising regulatory costs.
More switching between funds by investors, or creating giant ‘low-cost’ funds may not create better investment performance. Indeed, switching by investors and their advisers may be as much as one-third of total investors costs, possibly bigger than management fees. And moving investors into cheaper share classes hardly moves the needle when performance differences can be an order of magnitude higher.
These challenges point to the core problem; lack of remedy. Performance variations between funds tend to be much larger than cost differences, and performance persistence within an individual fund is usually not reliable - as the risk disclosures warn. Reducing charges or closing funds sounds like effective remedial action but may not be the change investors really want. Investors can end up bearing fund merger costs or otherwise be adversely impacted by closures. There is a risk that money can be out of the market for a period or that an unhelpful tax event is created. Regulation may no more be able to create consistent performance than it can foster competition. Increased competition often stems from pricing flexibility and disruptive approaches. Prescription can stifle innovation and longer term competitive forces.
Can well-intentioned regulation ever be harmful? It may take time for unintended consequences to emerge. The initial metrics did not recognise some issues of public interest. Active managers believe they contribute to responsible corporate behaviour, sustainability, price formation in the stockmarket and trading liquidity. Focusing on cost and service may overlook key roles played by managers in signalling values and bringing non-financial factors into price formation. These are public goods that cannot be recognised in a narrow snapshot of investor value. And the resources involved in producing the reports may be considerable for managers taking the assessments seriously.
The FCA is reviewing results with a cross section of managers and has said that it will be taking a close interest in whether fund managers have complied with the spirit of its framework. Certainly, funds are closing but whether this drives-up competition is open to question. Not all small funds perform badly, just as the largest may not be optimal for investors either. The industry and investors alike await the regulator’s next move.
A version of this article was published in Financial News on 12/11/2020.