Late June 2012
It is more complicated than you think
Whoever assembled the 212 slide PowerPoint presentation for Deloitte that accompanies the FSA consultation paper on payments to platform service providers deserves a medal. Well, at least a seat in the House of Lords while it still exists. The work is a complete explanation of the internal plumbing of the distribution of retail financial products. Those of us that work in it know it is far more complex than it seems to outsiders. But I imagine few of us realised it was this complicated. Therefore full credit must go to the FSA for trying to simplify it.
And yet the accompanying consumer research paper by NMG suggests that the effort will be in vain.
To grossly simplify the exercise the FSA believes that investors will be better off if they understand exactly who pays how much to whom in the industry and that the resulting competition on price will force down costs and prices. Fine in theory but the evidence from the NMG study demonstrates that price is not currently a consideration for investors or advisers. NMG and FSA believe that disclosure will prompt price competition in fund and platform fees. However, there is no indication that will happen. What the study demonstrates is that “reputation” and “potential performance”, perhaps better labelled as brand, were the main criteria for fund selection. Hardly any of the 65 interviewees used price to select funds. Indeed they were even unable to describe the financial relationships between fund, advisor or platform and therefore were unaware of who charges what.
The FSA aims are laudable, and ones we fully support as a low cost provider. But the truth is that that the public does not recognise that a problem even exists. They are therefore unlikely to act on information they are given to solve it.
The real problem is that the investing public does not understand the world of finance. Because of that the investment decisions they make are often not in their best interests. There is of course no law in any industry that prevents people from buying unsuitable goods and services that benefit the seller more than the buyer. But market forces are a powerful mechanism to use the wallet to change industries.
A few decades ago no one decided that airlines charged too much and were aided and abetted by travel agents. Freddie Laker hit on the idea of using cheap second-hand airliners to offer cut price air fares. A vicious campaign by British Airways drove him out of business but the financial logic remained and first Virgin then Ryanair and easyJet exploited the niche to create very successful businesses that also hugely benefitted the traveller. Along the way many travel agents suffered collateral damage, but that sector has adjusted and still survives.
The big difference with funds is that budget airlines could advertise directly to customers. Once passengers could see that that the service of getting from A to B was exactly the same save for a sandwich and a seat with their name on it they voted with their credit cards to save hundreds of pounds each time they flew.
What is missing in the debate about platform and fund fees is simple information about the prices offered and the services provided. The FSA proposal only addresses prices. Most funds do pretty much the same thing. They essentially sell the returns of the asset class, what it known in the trade as beta. Flying from London to Glasgow takes as long with British Airways as easyJet. That is the basic service, the beta. The differences between the two, like a sandwich and a designated seat, are the extras you pay for. In fund management terms this is known as alpha and is essentially the higher risk a more aggressive fund takes hoping to get higher returns. What investors are not told is exactly what the fee is for each fund and what the fund does to try and give a better return. With airlines you know about the sandwich and the seat. Trying to get that information for funds is much harder. And, unlike the sandwich, you don’t always get the higher returns.
What the FSA should be doing is focussing on information as well as prices. As any student of economics understands price is an outcome of market forces not an input as communist countries eventually discovered. Where the FSA has got it wrong is preventing fund managers from publicising the information to the public that will allow it to discriminate between higher cost and higher risk funds from simple plain vanilla funds. It is the rules on advertising that allow managers to sponsor racing yachts but not disclose how much risk each fund is taking. Concepts like the information ratio, a measure of risk adjusted returns are no harder to understand once they are explained than miles per gallon. Why doesn’t the FSA trust the public to learn the basic rules of investing?
To be fair to the FSA the problem of platforms is largely one that successive governments have created by designing tax wrappers like ISAs and SIPPs that have to be held by a third party. On top of that anti-money-laundering rules are a strong disincentive to shop around and open up fresh accounts with different platforms to compare services.
The world of retail finance is far more complicated than it need be and there are so many things we would like to change. There is though one thing that is perhaps more important than the rest and that is corporate governance. Directing attention to price not service is going to encourage investors away from OEICS into ETFs, and the cheapest of these are synthetic. This means they don’t hold the underlying stock and therefore cannot vote and follow the Stewardship Code. In other words ETF investors are disenfranchised. It could be that the unintended consequence of these developments reduces corporate accountability just as Professor Kay is seeking ways to improve it.
(The S & W Munro UK Fund is a physical long-only smart-beta fund that invests in the FTSE 350 Index and complies with The Stewardship Code.)