Shaming dogs with data is better than asking regulators to shoot them
The revelation this week that the United Kingdom government will after all force retirement funds to disclose management and performance fees and transaction costs is good news for alternative fund managers. For decades, dozens of long only managers have delivered nothing better than beta at exorbitant prices, and often something worse than that, especially after transaction costs are added to explicit fees.
The legislators in the House of Lords that embarrassed the government into introducing the necessary amendment are hopeful that disclosure will lead to more intelligent buying behaviour on the part of corporate and public sector funds as well as retail investors. Much will depend, however, on the ability of private sector analysts to turn a mass of data into intelligible information about the relationship between costs and performance.
There is no simpler measure of the inefficiency of the United Kingdom fund management industry than the sheer number of mutual funds in existence. According to the data published by the Investment Company Institute (ICI), there are 1,913 mutual funds in existence in the United Kingdom today, with an average net asset value of £356 million. In the United States, by contrast, there are 7,605 funds, whose value averages $1.9 billion.
True, the scale of the British funds industry is rising. Five years ago, there were 2,266 mutual funds in the United Kingdom running an average of £198 million. Rising equity markets account for some of the improvement and, even now, the sheer number of funds bears mute testimony to decades of flavour-of-the-month fund launches and meaningless innovations designed to distinguish yet another equity fund from the hundreds in existence already (two thirds of British funds are invested in equities, against a global average of just over a third).
By definition, half these funds are languishing in the bottom quartiles. It says a great deal about the economics of the fund management industry that it can sustain quite such a large number of under-performing products. If supermarkets operated on the basis that half the products they stocked were demonstrably less valuable than the other half, they would not remain in business for long.
It would be easy to blame investors for idleness and irrational behaviour, and the expectation is that more information will prompt a more actively sceptical approach on the part of retail investors. Today, the criticism of wilful investor ignorance has more force in the case of institutional investors in the United Kingdom. Their wilingness to believe anything their investment consultants tell them, coupled with an equally obtuse unwillngness to measure costs and performance, accounts for a great deal of the inefficiency in the United Kingdom fund management industry.
In the retail market, the persistence of multiple under-performing funds reflects the distorting effects of commissions, in which countless independent financial advisers (IFAs) have for decades pushed on to their hapless clients whatever fund pays the highest commissions. It will be interesting to see what effect the Retail Distribution Review (RDR), which switches the rewards of IFAs from commissions to ad valorem fees on assets under management, has in the long term on the structure of the United Kingdom mutual fund market.
It came into effect on 1 January 2013. The earliest observable effects included a switch from commissions to fees, but in the form of percentages rather than cash, so that investors did not get too alarmed by the price of advice. It was also obvious that old habits were dying hard, with many IFAs claiming to be independent in fact selling a narrow range of funds from a small group of managers. There is also a distinct reluctance to explain to investors what exactly they are paying for.
From 2016, the updated Markets in Financial Instruments Directive (MiFID II) will begin to spread the logic of RDR throughout the European Union, where commissions still reign supreme in most markets, though the fund distributors have emasculated the bolder ambitions of the measure. As a result, commissions will survive in continental Europe long after MiFID II has done its worst.
Unsurprisingly, the sub-scale mutual fund is a problem in Europe as a whole, where 34,739 mutual funds manage an average of €190 million each. In France 7,249 funds are running an average of €152 million. The equivalent figures for Spain are 2,280 and €73 million, while in Italy 651 funds have an average value of €233 million. In Belgium, the 1,432 funds still at large have an average value of just €47 million.
There is a view that the mutual fund industry is incapable of reforming itself. RDR and MiFID II -which have shown that commissions can survive such measures - certainly support that view. If the market forces unleashed by the publication of explicit and implicit charges in the United Kingdom fail to spark consolidation and competition in United Kingdom fund management, the regulators may even be forced to do the necessary work on behalf of the mutual fund industry.
That means obliging managers to close down or merge with another fund which has under-performed for more than a set number of years. The question is how long a period should be set. Five years or three? Or should it be a complete market cycle? Regulators are bound to get it wrong. But so are fund managers, whose efforts to rid themselves of small and under-performing funds inevitably run into the self-serving argument that they are still making money for the firm. Making it obvious that the fund is not making money for the investors is a much better solution than regulators putting a time limit on the life of a dog. Let us hope that is among the consequences of the greater disclosure promised to investors in the United Kingdom this week.