Interim findings of the FCA’s asset management market study

This article is a deeper analysis of our asset management market study client call.

On 18 November 2016, the Financial Conduct Authority (FCA) published its interim findings on the asset management market study. The market study was launched in November 2015 in order to explore whether competition was working effectively in the asset management sector and whether institutional and retail investors are getting value for money when purchasing asset management services.

Interim findings and proposed remedies

The FCA’s interim findings report covers a broad range of themes. Indeed, whilst the market study has been conducted under a competition banner, the proposed remedies go much further and have the potential to fundamentally impact how the industry operates. For that reason, it deserves attention now, even though it contains proposals for change in the future, rather than new rules effective now.

The FCA found that:

• price competition is weak, particularly for retail funds and active funds
• investor choice could be restricted by a lack of information, and
• there is a lack of transparency in relation to objectives and investment outcomes.

To address its concerns about how the industry operates, the FCA proposed a significant package of remedies, which include:

• a strengthened duty on asset managers to act in the best interests of investors
• requiring clearer communication of fund charges and their impact at the point of sale and in communication to retail investors
• requiring increased transparency and standardisation of costs and charges information for institutional investors
• introducing an all-in fee to make it easy for investors to see what is being taken from the fund
• measures to help retail investors identify the most appropriate fund
• exploring with government the potential benefits of greater pooling of pension scheme assets, and
• recommending that HM Treasury also considers bringing the provision of institutional investment advice within the FCA’s regulatory perimeter.

The FCA is also consulting on its provisional decision to refer institutional investment advisory services to the Competition and Markets Authority (CMA) for market investigation. If the CMA did investigate this market, this would result in a further in-depth probe of investment consultants and how they fit in to the wider industry. More onerous remedies might also follow.

Investor choice and interests

Investor choice and investor protection continue to be the key driving forces behind many of the FCA’s proposed remedies. For example, the suggestion that asset managers need to be clearer and more transparent in their communication on costs, performance and objectives is as a result of its conclusion that investors are often unable to judge whether a firm is offering value or money. Similarly, the FCA’s concern that investors are often unable to switch to another fund with ease, thereby reducing investor choice, has led to its proposal that there should be “no more excuses” in making it easier to switch investors into better value share classes. Indeed, the FCA’s findings suggest a shift towards it taking a more active role as "performance regulator". It threatens to "shine a light" on long term underperformers to encourage switching.

The FCA also found that the industry was not particularly focused in the best interests of the investor. This may have been the rationale for its suggestion that a strengthened statutory duty be placed upon asset managers to act in the best interests of investors, as well as hinting at the introduction of mandatory "benchmarks" so that investors are able objectively to assess the performance of asset managers.

Of course, this begs the question of how fund performance and value for money can be assessed, if the FCA’s agenda is followed. For instance, fund governance committees will need to assess and challenge how "value for money" is being delivered and evidenced. Additionally, it remains to be seen how funds might be expected to demonstrate compliance with a strengthened duty to act in the best interests of their clients.

Pricing

It is clear that the FCA considers competition to be weak in this industry, particularly in relation to price. For instance, the FCA found price clustering for active equity funds and commented on the reluctance by firms to undercut each other by offering lower charges. This sits alongside a generally high profit margin in the industry, which the FCA believes is a reflection of the lack of price competition and asset managers absorbing any benefits from economies of scale.

Treating customers fairly and the need to deliver clear, fair and transparent pricing and communications are not new concepts for the industry, but the FCA now appears to be determined to formulate and impose detailed rules upon the asset management industry in order to improve standards - as is apparent from the breadth of its remedy proposals.

Proposed extension of the regulatory regime

The FCA’s concerns in respect of institutional investment advice have resulted in a proposal to extend the regulatory perimeter through legislative change. The FCA proposals would bring certain services such as strategic asset allocation and manager research and selection, which can currently be conducted without authorisation, within the regime. Firms impacted by this proposal might need to conduct contingency planning to understand how they might manage the cost and structural burden of regulation.

Contentious regulatory risk issues

Conduct risk issues are inherent in the findings of the FCA, which at its heart, concerns how asset management funds are structured, described, sold and managed. The findings extend to how the various roles in any structure are performed, how conflicts of interest are managed and how funds report on performance to investors.

Whilst there is no immediate threat of FCA enforcement action at this stage (under the Financial Services and Markets Act (FSMA) or its competition powers), it is important that firms can demonstrate real engagement with the issues raised in the report and use this opportunity to provide feedback to the FCA through the consultation process.

The FCA will expect active engagement of both business and senior management in the issues and risks identified in the report. The ability to demonstrate real ownership of these issues by senior management will be especially important as the FCA moves towards extending the Senior Managers Regime to asset managers in 2018 and seeks to hold individuals to account.

As the market study process progresses, firms should consider how to handle potentially contentious issues which might arise as a result of these findings, for example investor requests for additional information on costs, fund structure and committees, performance and objectives or complaints about the clarity of promotional materials.

Litigation risk issues

The FCA’s investor protection agenda is clear in the proposed remedies, and although not intended, might further increase the trend of investors seeking redress from asset managers in harder economic times. Of the FCA’s various proposed measures, the strengthened “best interests” duty is the clearest indicator that asset managers’ risk outlook may be about to change.

To the extent that such litigation risk drives stronger governance and conduct that better meets the FCA’s expectations, the FCA would no doubt consider its objective achieved. From the asset manager’s perspective, it will be important to consider how this increased litigation risk can be managed and mitigated.

In that regard, the interim report provides some useful examples of conduct that - in the FCA’s view - might constitute a failure to act in accordance with the strengthened “best interests” duty which it is proposing. Those examples include:

• failure to ensure value for money (eg by scrutinising fund fees and charges)
• failing to challenge retention by the manager of “box profits"
• unjustified differential charging of retail and institutional customers
• failure to ensure that investors benefit from economies of scale, and
• charging a management fee calculated to reflect fully “active” management if in reality the fund is only managed in a “partly active” way, with only small deviation from an index.

Asset managers wishing to protect themselves against future claims will also need actively to consider their funds’ governance arrangements, together with conflicts of interest policies and procedures. The FCA’s interim report concludes that governance structures commonly display an insufficient degree of independence from the asset manager’s own interests. This is a theme which the whole industry will need to watch closely when the FCA’s publishes its final report next year.

Market investigation reference to the CMA

The FCA’s assessment of the institutional investment advice market is also unsympathetic. The FCA is consulting on whether to make a market investigation reference (MIR) to the CMA with respect to this market. Referrals such as these can only occur where the FCA has reasonable grounds to suspect that the market, or a feature of it, prevents, restricts or distorts competition and it’s consultation is open for comment to all those who might be affected by such a MIR.

The MIR would cover advice given to institutional investors1 on asset allocation and manager selection; and (ii) advice given to employers in relation to pension schemes, for the benefit of the employees. One key issue for the FCA is how the quality of the advice can be assessed, such as the service provided by the advisor and their speed of response, particularly given that three key market players hold 60% of the entire market.

If the CMA does conduct a market investigation, then institutional investors (and the industry more generally) should prepare for a level of scrutiny from the CMA that it has not yet seen from the competition regulator. The CMA may then take steps, such as recommending new regulations to the FCA, if it finds that there is an adverse effect on competition within this market.

The FCA’s consultation on the MIR closes on 20 February 2017.

What next

The interim findings affect a number of players from across the industry - asset managers; pension funds; trustee services; private equity firms; hedge funds, as well as industry service providers eg investment consultants. The FCA only interviewed a relatively small number of industry participants (37 asset managers, 13 investment consultants and 8 platforms), but its proposals are very broad ranging.

The interim findings consultation presents the industry with another - final - opportunity to provide the FCA with thoughts and comments, in order to ensure the FCA’s final report and remedies (due in 2017) truly reflects the views of industry participants. The FCA’s consultation on its interim findings closes on 20 February 2017.

1Pension schemes, charities, insurance companies and endowment funds