In previous blogs I have looked at the FCA’s Market Study’s position on investment consultants and what it has to say about transparent measures to help us understand what we are paying for funds.
But the bulk of the paper is concerned with what value investors are getting from the asset management industry and here I think it is (relatively) weak.
There is an absence of first principle of thinking underlying the FCA’s approach. I mean by this , a failure to engage with the question of why we need “funds” what role a “fund manager” plays and how @asset management” delivers something more than simply buying and holding a portfolio of stocks and shares.
In the past, it was quite usual for private individuals to purchase equities and bonds (stocks and shares) and hold them with no more than a pile of certificates to show for it. Prices were tracked in the newspapers, dividends and fixed interest payments received by cheque and capital gains tax calculated at the point of sale.
This DIY approach to asset management might be assisted by a stockbroker who could recommend rudimentary tax-planning through bed and breakfasting but who never aspired to the status of “financial adviser”.
This disinter mediated approach has been superseded.by a reduction in direct investments, an increase in the use of funds and the employment of fund managers, investment platforms, tax wrappers and financial advisers replacing the simple ways of our parents.
It is easy enough to point to what has been gained – an army of professionals, online access to fund values , a myriad of funds, best buy lists and model portfolios. But at what cost? When a private investor chose to buy Cadbury, it was a decision based on the Cadbury business model, management ethos, on the financing of Cadbury and it’s dividend policy.
Direct ownership had a clear purpose, there was an alignment between the stocks and shares people bought and their view of the world. Sometimes people bought on a stockbroker’s recommendation, sometimes they even followed share tipsters in their newspaper, but for the most part, people were investing “their way” and expected to be accountable for the success or failure of their decisions.
This aspect of investment has been entirely lost by intermediation. Where people chose funds today, it is because of the reputation of a Neil Woodford or a Terry Smith, or because a fund is 5* morningstar rated or because it appears on the Hargreaves Lansdowne 100.
The FCA report looks at these measures and concludes that by and large people would be better investing passively. This is undoubtedly empirically right. One is left wondering why morningstar ratings downrate passive funds and why best buy lists typically include no more than 20% index trackers. Even more puzzling, why 80% of advised retail investment is still going into active funds.
I think the answer to this question is because people still believe that asset managers are important and provide a valuable service, though they have no idea what that is.
The FCA paper is weak on this. It does not properly engage with the end investor and ask what he or she is looking for by way of value. Instead it relies on a consumer survey from an organisation called NMB which has delivered a series of charts that I find very difficult to relate to.
This for instance is what influences the decision of a retail investor to buy one fund over another.
According to this , where the fund invested in , is only a medium ranking factor (30%). Far more important at 45, 44 and 43% respectively are the charges, past performance and the likely future performance of the fund. Indeed the reputation of the fund manager is more important than the assets being purchased.
There is a real problem here, what Con Keating , David Pitt-Watson, John Kaye and others refer to as the “problem of agency”. Put simply, we are buying reputation and hunches about performance and our only meaningful risk measure is the level of charges.
I am not entirely sure that retail investors properly understand “charges”.
If less than half of retail investors don’t believe they are paying charges, what credence can we give to their assessment of “reputation” and “likely future performance”. Of all the measures they assess for value “past performance” seems the one that is quantifiable. Though the FCA spend much time discrediting it.
Things are little better when we look at what institutional investors choose funds by
This differs only marginally when investment advice is taken.
What is notably absent in any of the research of consumers (retail or institutional) is engagement with what asset managers actually invest in and why.
Why ownership matters
Going back to the first principles, it’s worth looking at the “problem of ownership”. Let’s take a stock – Raytheon – Raytheon makes (among other weapons) cluster bombs. It is not illegal to sell cluster bombs though it is illegal to drop them on people. It is entirely possible that cluster bombs will become very popular in the future and you may think that Raytheon is entirely the kind of stock you want in your portfolio, then again you might not. But for many people, a portfolio that avoided investing into companies that thought cluster bombs were a good thing to make and sell, might be a good portfolio.
Let’s take as another example, the carbon footprint of the company you own in your portfolio. It might generally be thought that companies with low carbon footprints relative to their rivals would be better placed to prosper in a low-carbon emission world than companies that do. This is the commercial justification for investing with environment social and corporate governance (ESG) in mind.
ESG “factors” are only a few of literally hundreds of factors that you could choose as your principals to choose stocks by. Going back to the portfolios people put together for themselves, factors were all important. My Dad bought London Brick (now part of Hanson) because he thought that there needed to be a lot of houses built in the 1960s and 1970s. It was a good call. My mother’s father bought into Guinness shares (now part of Diageo) because there was a baby in every bottle (not such a great factor – though holding proved a good investment).
If we are going to understand the value of asset managers, it has to be from an understanding of how they choose and hold assets. As importantly, it has to be about how they act as our proxies in asset ownership. Increasingly we are seeing asset managers exercising voting rights to ensure that the managers of the companies they own, behave in an acceptable way.
Is the value of ownership suffeciently recognised in the FCA’s paper?
To my mind, the FCA is adopting a reactive approach to “value”. Both the NMG retail research and its proprietary institutional online survey simply don’t frame questions to consumers in such a way, that consumers can comment on what the asset managers were actually doing with the money.
Reading the methodology employed in the online survey, it was as if the factors that governed stock selection and retention were simply not of interest. The same could be said of reading the NMG technical report.
NMG are currently conducting a survey for IGCs on the value of a workplace pension. I fear that – like its survey for the FCA – it will frame questions about value in terms of what the industry sees as important, rather than the end investors.
There is ample evidence that when framed another way, most investors would much prefer to have their money managed with an eye to environmental, social and corporate governance principles in mind. For corporate evidence, read this report by Share Action. For consumer reaction, read the research conducted by HSBC on its own DC scheme members.
I suspect that if you asked ordinary consumers what asset managers do , they would say they managed assets and if you asked them what made them good or bad, they would talk about how well they managed assets. They would not talk about past performance, future performance or even costs and charges, they would be thinking about the assets and how they were managed.
If past performance is not the measure – what is?
Performance measures – whether risk adjusted or not – whether published net or gross of fees, do not measure what an asset manager is doing. The alternative to looking at past performance is not laid out by the FCA- but it clearly needs to focus on how asset managers manage assets.
Until we have clear measures about what good management of assets looks like, we will not get a long way towards a metric for value. That is the next challenge!
In my view we need to go back to the first principles, look closely at the problem of ownership and then work out what factors matter. If we can only understand factors by building index around them, then there is no future in active management.
But if we believe that asset managers can materially improve the markets whose assets they manage, we need to understand how.