Specialist Outlook

The times they are a-changin’

27 October 2015

All industries evolve over time as they adapt to the changing environment. While some changes are predictable, the factors driving them obvious and their impact gradual, other shifts happen much more quickly, and for reasons far less well understood by all but a few futurologists. 

While the speed with which technology companies can gather market share is now understood, the direction of change can still surprise: who other than its founders and initial backers considered that a company like Uber would shake up the highly regulated and ‘closed’ taxi industry to the extent that it has? The investment management industry is no different. Investment markets develop, new asset classes come to the fore, styles of management go in and out of fashion, tax rules shift and there is a constant need to adapt to ever-changing compliance and regulatory standards.

The changing face of investment management

Against this backdrop, the way in which the investment management industry administers, invests, charges and reports to its clients has changed dramatically. It is worth considering for a moment what has changed and why: many of the changes will be very visible to clients, others less so and some which are about to happen are worth being flagged in advance. In some instances, tighter regulation was sorely needed, but the wall of regulatory change has also had some unintended consequences. Moreover, the reasons for and consequences of some decisions taken by investment managers might not have been fully explained to their charity clients.

Some charities will be classified as Per Se professionals, but the majority are usually classified by their managers as ‘retail’ investors: this means that they get the maximum regulatory protection possible. If your charity is not classified as a retail investor, it is worth exploring why this is the case. If one considers how investors have fared over the past twenty years, it is not surprising that the authorities are trying to make their protections for non-professional investors as watertight as possible. It is also not surprising that some managers find adhering to these new rules margin-sapping and burdensome.

Markets have been volatile and this has brought problems. While the dramatic stock market collapses in 2000-03 and 2007-08 were classic equity market crashes and to some extent, expected, they wreaked havoc with investors and their managers who were not prepared for such gyrations. The fact that far too many discretionary managers had not spent enough time considering the strategic goals of their clients in great detail has led to, in modern regulatory parlance, a culture of proven ‘suitability’. For investment managers with strong strategic credentials, the regulator’s push to improve the quality of firms’ suitability assessments has not set them back.

However, other investment managers less well-versed in in-depth client reviews and strategic guidance have, in several instances, chosen to back away from providing discretionary services entirely. This is probably a good thing for charities: regulatory changes have resulted in fewer managers all doing something properly, as opposed to the past when larger numbers were risking clients’ assets by doing it poorly. We suspect that suitability is an area the FCA will look to enhance further. We remain concerned about strategies we see described as being ‘medium’ risk, for example, and feel this is a long way off best practice and liable to significant misinterpretation. Trustees should expect their managers to check and challenge them more deeply and regularly.

Where else can clients expect to witness change over the next five years?

We have already seen the impact of RDR (Retail Distribution Review) – which was designed to raise industry standards, improve the clarity of investment advice and improve transparency) and MiFID (Markets in Financial Instruments Directive). These are Europe-wide directives designed to provide, amongst other things, the investor with greater protections and full disclosure on key governance areas such as the management of conflicts of interest, and execution policies. If you have witnessed changes to your charging structure in the past couple of years, they were almost certainly driven by the regulator and not by the altruism of your investment manager!

However, despite an increase in transparency, more is to come in this area. After the financial crisis and a number of investor protection failings Europe-wide MiFID is being comprehensively revised to improve the functioning of financial markets and strengthen investor protection.

This momentum gathering snowball of regulation is unlikely to slow anytime soon: Trustees should become accustomed to an environment of increased paperwork. There is little doubt that we will experience greater transparency within the industry.

The changes brought about by RDR have deconstructed fees for those with advisory portfolios so that retail investors have a greater understanding of what they are paying for advice. It has to be right that regulators will move to an equivalent level of transparency for all investment services. There is a chapter in The Compendium of Investment with a checklist for those wishing to deconstruct the fees to ensure they know exactly what they are being charged. But there is still no industry standard and the TER (Total Expense Ratio) is different from the OCF (Ongoing Charges Figure) which in turn is subtly different from the actual all inclusive costs paid by clients. By early 2017, we expect regulations will require investment managers to present all charges in actual pounds (as opposed to schedules that require the client to do some complex maths) what monies are being extracted from a portfolio. This could prove entertaining!

Included within these figures, given direction from ESMA (European Securities Markets Association) to the European Commission, is likely to be a figure for ‘research payments’ and clients may be required to sign up individually to agree to their use. This is by no means certain, but if it is endorsed by the FCA, it might be the final step in deconstructing and documenting what clients pay to their investment managers.

The reporting of performance figures has also experienced change recently. Notwithstanding the volumes of accompanying disclaimers that come with them, they are undoubtedly clearer now there is industry guidance as to how they should be laid out. We welcome this area coming under the regulatory spotlight, as it will ensure Trustees have comparable numbers that demonstrate how their investment managers are performing.

The unintended consequences of technological advances

In tandem with these changes, the industry has experienced some huge technology-driven steps forward. This has impacted both the way in which the industry reports to its clients, as well as the way in which business is transacted. While this has enabled Trustees and charity executives to find out the value of their portfolios at the push of a button and assists with many accounting procedures, it could also be creating a shorter-term approach to investment. We spend considerable time persuading our clients to think about the long term, and that investments can be volatile. Seeing the value of one’s investments change week-by-week masks the overall purpose of the portfolio, which is to increase in the long-term capital value.

Technology has also enabled the advent of dealing platforms, which allow investors the opportunity to pick investment funds in a similar fashion to choosing shirts or groceries from the supermarket. Almost half of retail funds are now sold via these platforms, run by the likes of Hargreaves Lansdown, Fidelity and Allfunds.

While these websites typically offer investors a choice of more than 2,000 funds, they often also suggest a smaller panel of ‘recommended’ funds. This in turn has led to more money being managed by fewer people; according to a report by Deloittes on the investment management industry two years ago, about 90% of money went into just 10 funds. So, while the initial conclusion might have been that these ‘platforms’ would have enabled a wider selection for the investor, they have actually played a part in creating a greater concentration of money in the hands of fewer managers.

So where does all this leave Trustees, and what will be the unintended consequences of the next round of regulatory changes and technological advances?
We suspect that the most significant change to the industry will be that bigger companies, those that can bear the increasing cost of regulation, will continue to survive. This will in turn lead to the merger of smaller investment management houses in order to achieve economies of scale. In addition, the larger firms will attempt to avoid the increasing regulatory burden of managing smaller accounts and increase their minimum size of portfolios for given levels of service.

The almost forensic detail and record-keeping required to manage discretionary accounts will cause investors to consider how much of the fees they are paying are being spent on administration, and how much is being spent on actual investment. Trustees of portfolios with less than £15m to invest are likely to find their choice of manager and methods of implementation becoming increasingly limited.

The law of unintended consequences may well be that the greater freedom and personal choice brought about by technological advances is more than offset by the increase in regulation which will reduce the number of players on the pitch. From a costs perspective, while increasingly transparent charging structures and reporting requirements will continue to drive out the worst and highest pricing practices, the increased regulatory burden may mean that the cheapest investment managers (many of whom provide services to charities) will have to increase their charges or reduce the all-encompassing services they currently offer.

In conclusion, we have witnessed significant change in the past 10 years. Investors are certainly better protected than they have ever been and the transparency brought about by the regulator has to be a good thing. Amongst other benefits, it is leading to lower and better understood charges, and will play a major role in getting rid of poor practices. However, we suspect the unintended cost to the client is likely to be one of reduced choice.

Ruadhri Duncan, Investment Manager, Charities, Sarasin & Partners

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Ruadhri Duncan

Business Partner, Charities
Ruadhri has over 15 years of investment experience in the fund management industry, where he has operated as both a fund manager and a charity trustee. After leaving the Army he started work with Leopold Joseph and Sons where he completed his fund management exams. In 1999 he moved to Newton Investment Management, where he worked within the charities department for over 12 years, joining Sarasin & Partners in 2011. Ruadhri is a Governor of Maidwell Hall School and a trustee of the Army Cadet Force Association.

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