Active investment commentary & analysis

Assessment of Value: The Challenges and Opportunities

SVM Managing Director, Colin McLean offers his thoughts on some of the challenges and opportunities after a second year of Assessment of Value.

Now, at the end of the second year of Assessment of Value for UK mutual funds, we can expect to see more comment on its strengths and weaknesses.  It is a good opportunity for initial appraisal.  Some of the professional and trade bodies and press that decided last year was too soon for an appraisal may now enter the fray.

The challenge of course is to separate out what Assessment of Value actually adds to value for investors in the marketplace and whether it has improved competition.  Indeed, the last point seemed to be the main aim of the FCA, despite an already strong trend for fees and costs to fall year by year.

And the challenge in reviewing the results of AoV is to separate it out from a wide range of existing regulation and practice.  There are already obligations on trustees, Authorised Corporate Directors and others with key responsibilities in service delivery.  And managers themselves have product governance, Treating Customers Fairly, conflicts of interest, a Senior Managers and Certification Regime, and MiFID trading cost analysis. All along with managers’ keen focus on their own competition position and reputation.

Investors and their advisers already have to pour through a range of information from fund reports to key investor documents, analysis services, and ratings provided by the industry.  No clear gap was identified in the information available to investors. A document that does not serve a need or gap is unlikely to be factored in with the additional work and cost that brings.  It would be unusual for an additional cost and regulatory requirement to actually increase competition, rather than marginalise some players and discourage new entrants.

Of course, scale alone can lower costs to investors, but that may not improve service.  It certainly makes regulation easier, except in a crisis when financial businesses can be too big to fail.  The costs on society of greater scale and industry concentration are indeed a hidden burden.  And most importantly, we know that active investment management tends not to increase returns with scale. Over time, returns tend to dwarf costs.

Some investors have seen returns of, say 14% per annum over the past five years, effectively doubling their money in that timeframe.  What is the right cost to pay for that?  1%? 2%?  We know that voluntarily investors in some areas of alternatives readily pay 2% and more for the privilege of accessing higher alpha with skilled managers, whilst also getting risk management and the public goods of stewardship and responsible investing.

Indeed, regulated public markets have significantly underperformed many private markets in recent years.  Yet, fair value is not a concept that is mandated within the Assessment of Value process.  It is as if there is a race to the bottom; checking service is comparable, but then focusing largely on a period of historic returns that may not be a guide to the future and on costs which are viewed against the industry’s moving goalposts.

Looking at one part of the wealth management and investment chain in isolation, risks missing unmonitored and sometimes unregulated cost elsewhere.  This matters, as we are increasingly seeing industry mergers of wealth and fund management that bring vertical integration. There is also some evidence that switching costs are high.  Closing or merging funds may have unintended consequences for investors, and switching between funds should not be taken as a measure of success for either Assessment of Value or the industry as a whole.  Why is this degree of churn not measured and factored into the regulatory framework?

Prescribed documents will tend to be more up to date than Assessment of Value, which is annual and may quickly become historic, particularly if a manager takes action on any recommendations. Fund costs may vary month by month according to fund size and there may be other information that is simply more important for investors than AoV and more up to date.

Only investors know their own time horizon and tolerance for risk and volatility – not always the same thing.  That means they may be using a fund in different ways than other investors, in combination with other assets to deliver a different risk reward profile.  AoV assesses fund but each fund serves a heterogeneous range of investors.

Should active and passive funds be combined in the same comparison? Certainly, passive funds tend to have lower costs, but arguably do not provide the same role.  Active managers are better placed to contribute to responsible corporate behaviour, sustainability, price formation in the stockmarket and trading liquidity.  Active managers have key roles in signalling value and bringing non-financial factors into price formation.  These are public goods that cannot be recognised in a narrow snapshot of investor value.

Certainly passives can vote and may have stewardship policies, but in general they cannot sell the stocks that constitute the benchmark they track.  And the price at which they do trade when money flows in or out of an index fund, or index constituents change, is set by the analysis and research of active investors.

It seems strange that at a time when there is more public interest in responsible investing and stewardship of businesses - recognising their broad responsibilities to society and a range of stakeholders - for Assessment of Value to ignore this.  It is an increasingly important component of value and individual investors may well prize it, too, even although the benefit is a public good.  Responsible investing is not costless. Integrating it with financial analysis in a holistic approach to investing - with long time horizons and actively engaging with corporate issuers and their boards - costs money to do well. It is anomalous that it gets no attention in Assessment of Value.

With no standard template, AoV reports have ranged in length from two pages to over 150 with a multitude of different approaches to value.  It duplicates parts of other living documents and also existing regulation on product governance and treating customs fairly.

It would be surprising if regulation created competition. Insofar as this might drive scale and churn, it may have some unfortunate unintended consequences.  In last year’s reports some funds in the industry were criticised because of cost arising from small scale.  Yet many of those smaller funds focused on smaller companies or less liquid opportunities. As they are able to concentrate portfolios, with more active share and alpha, many did in fact deliver some of the strongest performances for investors in 2020 and early 2021.  Should AoV give so much attention for the potential for scale to cut costs if that scale also comes with the risk of diminishing investor returns?

These challenges point to the core problem; lack of remedy.  Performance variations between funds tend to be much larger than cost differences and past performance 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 adversely impacted by closures.  There is a risk that money can be out 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 models.  Prescription can stifle innovation and longer term competitive forces.  We need to think about the consequences of what may is undoubtedly well intentioned legislation.

I would welcome more comment on AoV across the industry this time round.  If the process is to continue, there is potential for improvement going forward.