The Financial Conduct Authority’s recent report into the asset management industry didn’t go far enough for one frustrated fund manager. Requesting anonymity (but known to us at Monevator) they share their thoughts below…
The report by the Financial Conduct Authority (FCA) into the asset management industry [1] is, in the view of this writer, a lost opportunity.
Nowhere in its 144 pages does it mention the words beta or alpha. Yet the heart of the problem with fund managers is not costs, as the report focusses on, but miss-selling.
Active managers claim to deliver better returns than the average – i.e. to offer alpha – but the reality is that in aggregate active management fails to even deliver beta – i.e. the market return – because of the higher risks and costs associated with trying to achieve alpha.
As regular Monevator readers will know, the evidence is overwhelming. Over meaningful time periods, most active fund managers underperform [2].
Should not the fact that most private investors fail to understand or take this into account when buying funds be a key concern?
Cut out the middlemen
In its defence the FCA says it didn’t want to use the terms alpha and beta because they are too technical for investors to understand.
This is the second mistake the report makes. It consistently refers to ‘the investor’ yet the reality is that most funds are bought by intermediaries – that is, IFAs and wealth managers.
They are not the principals in the transaction but the agents. That gives then a very different incentive from the owners. As agents they are far less worried about the costs of ownership and returns, and more worried about the risk to their reputations and businesses.
As a consequence they would rather recommend a fund that appears safer than one that is cheaper. It is the old “no one ever got fired for buying IBM” argument.
There is a secondary element to this issue of who makes the purchasing decisions relative to who is the ultimate beneficiary, too. The agent has a vested interest in making his role look more complex and demanding to his customer than it really is.
If the end investor realised that it was not actually that difficult to buy beta then he would do it himself and cut out the middleman – and about 1% in charges.
After all, that is essentially what budget airlines have done by cutting out the travel agent and marketing direct to the consumer. It is the same with many products and services now sold over the Internet.
Massive cost savings are available by bypassing the distribution chain and going direct to the consumer. The consequences can be seen in high streets and shopping centres up and down the land as shops are closed and boarded up.
Truly disrupting the financial services industry
This brings us to the real failure of the report. It is still difficult for asset managers to present hard data, such as turnover rates, information ratio, beta or even compound interest directly to the public for fear of giving advice. Instead the FCA seems to prefer them to use intermediaries, who have a different agenda. This is what is preventing real competition from shaking up the industry, reducing costs and bringing in new ideas.
The FCA says fund management is too complex for the average investor to comprehend. In this writer’s opinion, that argument is fallacious. Mobile phones, computers, cars and TVs are far more complex than the average fund but that does not stop the population buying them and, by and large, making decisions in their best interests.
Why should that logic not apply to asset management?
The reason is of course that there are lot of well paid, and highly intelligent, people who have a vested interest in preventing the public from buying beta, the market return, very cheaply.
Instead, they want to sell alpha, the goal of outperforming everyone else, for a much higher price.
The illogicality of that argument is not lost on them but they respond by saying that while it might be true that, like the children of Lake Wobegon they all claim to be above average, they can always find some element of complexity – often related to tax wrappers – to persuade the investor he should be guided by an expert.
Expecting the public to effectively separate signal from very noisy data, and then factor in risk and costs is deemed far too onerous. Intermediaries get around that problem simply by using past performance, despite all its flaws.
A beta solution
As Upton Sinclair famously said: “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”
There will always be a need for intermediaries for more complex financial situations. However, the reality is that the average investor can satisfy much of his basic investment requirements by purchasing beta cheaply and simply through a passive fund without using an intermediary at all. The FCA report makes this no more likely now than before it was written.
If we really want transparency in this industry we need to use simple clear language to explain directly to investors what they are being sold. The FCA’s reluctance to use technical but clear labels like beta and alpha does not help the process.
Transparency is also aided when goods and services are sold directly by the provider to the consumer. Making it difficult to do this – and encouraging the use of intermediaries – makes transparency more difficult because the agenda of the agent is different from the principal.
Further reading
- The issue of intermediaries is set to be explored [3] in the FCA’s follow-up platform market study, which launched on July 17th.
- You can also download and read its Asset Management Market Study [4] [PDF].