Asset management market study Comments on the interim report

Transcription

1 Asset management market study Comments on the interim report Executive summary Publicly quoted closed-ended investment companies ( investment companies ) can deliver strong performance in comparison with their open-ended counterparts. Greater use of investment companies would increase competition across the asset management sector. The fact that they have not achieved greater market penetration with product providers and certain types of investors (notably IFAs) represents a market failure. The FCA s intervention to increase competition in the asset management sector should consider options to remedy this situation. Investment companies have benefits arising from their structure. They have independent boards that scrutinise costs. Many have reduced and restructured asset management fees to deliver better outcomes for their shareholders. Boards also actively consider the best way to deliver performance. The closed-ended structure ensures that investment priorities are not influenced by other considerations, such as the need to hold cash to meet redemptions. These, and other benefits, enable them to secure strong performance. Overall, investment companies have been more likely to beat their benchmarks than their open-ended competitors over 3, 5 and 10 years. The FCA s proposed remedies largely seek to influence how open-ended funds are managed and offered to investors. The AIC recommends that the FCA should also consider remedies that alter the competitive dynamics of the market, including remedies that seek to deliver a more diverse range of investment structures. The AIC recommends that asset managers offering collective investments should be required to consider whether or not the fund structures they choose provide the best opportunity to secure long-term investment performance given the funds underlying assets, investment strategy and, if it is open-ended, redemption policy. This process could include requiring a prospectus disclosure at launch setting out the promoter s conclusions on these issues. This assessment might not be the only influence on the choice of structure, but a greater regulatory focus on this area would aid competition and focus on how better outcomes for consumers can be achieved. The growing demand for investment companies from Independent Financial Advisers (IFAs), prompted by the Retail Distribution Review (RDR), shows that well-targeted regulation can enhance competition. The AIC supports maintaining the central elements of the RDR, including preventing the payment of commission and requiring IFAs to consider a suitable range of investment products. This should be a cornerstone of the FCA s efforts to secure effective competition in asset management. Given the potential advantages of investment companies, both as individual holdings and as part of a balanced portfolio, the FCA should also consider why more progress has not been made in increasing competition between fund structures in the IFA market. The AIC recommends the FCA considers what further steps might be taken to embed and enhance the impact of the RDR, including examining barriers to IFAs using investment companies as part of their strategy to build diversified, long-term portfolios for their clients. 1

2 Asset management market study Primary recommendation The interim report considers whether asset managers are delivering the right pricing and performance outcomes for consumers. It identifies deficiencies in both these areas and proposes remedies. The FCA should also consider more fundamental issues about the structures which asset managers choose to deliver their services. Using targeted regulatory interventions to inform how this choice is made could secure greater competition in the consumer interest. The track record of publicly quoted closed-ended investment companies ( investment companies ) in comparison with their open-ended counterparts shows that this structure has the potential to secure superior long-term returns for investors. It indicates that the tendency towards firms offering, and investors purchasing, standardised open-ended funds, whether actively or passively managed, denies investors the opportunity to build stronger portfolios better able to meet their investment needs over the long-term. Fig 1: Investment company performance vs open-ended funds and the FTSE All-Share 600 % growth FTSE All-Share Open-ended funds Comparable investment companies -50 Note, for the purposes of this paper, unless otherwise stated, open-ended funds means open-ended funds in sectors which trade in transferable securities where there is a comparable investment company alternative. The data used in this chart utilises the Investment Association Open-ended index. This includes all primary share classes of open-ended funds whether these are active or passive, retail or institutional funds. Source: Morningstar 2

3 Despite their impressive track record, investment companies are a far smaller part of the market than their open-ended competitors. While investment companies may not be the automatic choice for fund promoters and investors in all situations, their potential to deliver long-term returns in a range of asset classes suggests that they should receive greater consideration. The availability of different types of fund, with different investment characteristics should help drive competition in the consumer interest, with different structures gaining market share according to whether or not they are best suited to fulfil investors differing needs. This is not currently the situation, which suggests that there is a market failure in the funds sector. Arguments regarding the relative benefits of open-ended funds versus investment companies often focus on factors that may, in reality, be marginal considerations for many investors. For example, some critics highlight perceived risks arising from share price volatility. This may be a determining factor in a few situations, but its importance is often overstated. Most investors are seeking long-term exposure to an investment opportunity. Where this is the case, if they have already captured strong long-term performance, small short-term variability in the price they might receive when they sell their interest has very little impact on the overall return received. It is difficult to conclude that volatility of this type provides a compelling justification to exclude investment companies as an option for most investors. Another concern raised is the potential for shareholder returns to be squeezed if there is thin liquidity in the shares when the investor wants to sell. This issue could be a relevant for very large investors seeking to sell many millions of pounds of stock quickly. It is unlikely to be an issue for many others. Certainly, it is difficult to see that this will be a problem for most selfdirected retail investors or the clients of most IFAs or wealth managers. It is, of course, a concern if the operational preferences of these intermediaries (for example, outsourcing to model portfolios) were to create liquidity issues which would not be a consideration were investments solely being made on behalf of an individual investor. Nonetheless, even in the context of large holdings, concerns about liquidity should not prevent many investors holding larger investment companies. When potential concerns about holding investment company shares are considered in context, they are often less significant than is sometimes claimed. This suggests that fund promoters and investors are often blinded to the benefits of the sector because of force of habit or market practice, rather than undertaking a measured assessment of the pros and cons. These factors result in a less competitive market for asset management than could otherwise be achieved. The benefits of investment companies are also overlooked when promoters are seeking to offer exposure to illiquid asset classes, such as property. Long standing concerns that openended structures are not best suited to illiquid assets has not stopped the open-ended direct property funds sector becoming some three times the size of its investment company counterpart. The use of open-ended funds to offer exposure to property raised concerns for investors and regulators when providers were forced to act to protect the integrity of their products following the UK s vote to leave the EU last summer. Substantial demand for redemptions highlighted fundamental problems about mismatches between the redemption policies offered by openended funds and the illiquid nature of property assets. Providers were forced to take a range of actions, including suspending redemptions. These same market conditions did not see 3

4 Asset management market study investment companies changing the terms they offered to investors or being forced to take any other action in relation to the underlying assets. The fact that investment companies have not developed a greater market presence raises questions about incentives in asset management and distribution. It suggests that possible remedies should address more fundamental questions about product design if they are to materially increase competition. A larger market presence for investment companies would make it more difficult for intermediaries, such as IFAs, not to consider allocating a greater proportion of their clients assets to the sector. We estimate that investment companies account for less than 1% of IFA recommendations by value on an annual basis. More than half of IFAs use no investment companies at all, for any of their clients. It is unclear why this is the case. Direct retail investors have been well served by investment companies for many years and are much larger holders of their shares. Lack of interest from IFAs reduces competitive pressures that could otherwise encourage asset managers to price their services more keenly and deliver better performance. The FCA s proposed remedies largely seek to influence how open-ended funds are managed and offered to investors. The AIC recommends that FCA should also consider remedies that alter the competitive dynamics of the market, including remedies that seek to deliver a more diverse range of investment structures. The AIC recommends that asset managers offering collective investments should be required to consider whether or not the fund structures they choose provide the best opportunity to secure long-term investment performance given the funds underlying assets, investment strategy and, if it is open-ended, redemption policy. This process could include requiring a prospectus disclosure at launch setting out the promoter s conclusions on these issues. This assessment might not be the only influence on the choice of structure, but a greater regulatory focus on this area would aid competition and focus on how better outcomes for consumers can be achieved. The FCA s efforts to increase competition in asset management should not only consider the delivery of existing services. It should also encourage asset managers to offer more competitive products. The AIC recommends that asset managers offering collective investment products should be required to consider, and justify, whether or not the fund structures they choose offer the best opportunity to secure long-term investment performance. This should include assessing open and closed-ended options to identify which has the capacity to deliver better outcomes for their clients and beneficial owners of these investments. This proposal could be achieved in various ways, for example, by requiring that prospectuses for collective investments include a disclosure on this analysis, setting out why the structure chosen is most appropriate given the underlying assets, anticipated holding period etc. 4

5 The investment company sector The sector comprises 387 companies, with just over 150 billion of assets under management. These companies fulfil the traditional functions of a fund, by pooling capital, providing access to a diversified portfolio of assets and giving investors access to expert fund management. Fig 2: Overview of the investment company sector Type Number Total assets ( bn) Market cap ( bn) UK domiciled companies (ex VCTs) UK domiciled VCTs Non-UK investment companies Total Open-ended funds 3,602 1, Source: AIC, investment company data to Open-ended funds data from the Investment Association, including both active and passive funds, to The investment company operating model Investment companies are established in accordance with company law and governed like their trading company counterparts. They have boards of directors. Directors have legal duties to uphold investors interests. The board is the ultimate decision-making body within the company: it determines how the resources of the company will be allocated to deliver its investment strategy. Key decisions on the future of the company are subject to shareholder approval. These include, for example, whether or not to change the investment strategy, external asset manager or any other external supplier, whether or not the company should continue to exist or additional shares should be issued. For a more detailed discussion of investment company governance see Structural advantages of investment companies, below. Investment companies organise their activities in a variety of ways. Some are self-managed. That is, they employ staff to manage the portfolio and perform administrative functions. These companies do not employ the services of an external asset management firm. The majority of the sector adopts an outsourced model whereby the board appoints an external fund manager, and other suppliers, to undertake the day-to-day activity of running the company. A few investment companies appoint one or more external fund managers with discrete investment mandates. Some appoint a separate external administrator. Investment companies also utilise the services of other external advisers (such as corporate brokers, legal advisers, accountants and auditors). 5

6 Asset management market study Critically, from the investors perspective, investment companies differ from open-ended funds as there is no external operator with control of the company and its arrangements which has incentives to extract a profit from the customer to provide a return to their own shareholders. The investment company, personified by the board of directors, is its own operator. In this case the shareholder and customer are the same. The benefits of delivering strong investment performance and value for money are captured by the investment company s own shareholders. Impact of the RDR Investment companies are held by investors of all types. This includes institutions such as pension funds, wealth managers (with both discretionary and advisory mandates) and selfdirected retail investors. An important exception are the clients of IFAs. Their low level of holdings is a legacy of commission-based remuneration. Investment companies are restricted in their capacity to pay commission as company law prohibits shareholder funds being used to support the company s share price. As the majority of IFAs were remunerated via product commission, most ignored the sector, irrespective of the benefits that it might offer to their clients. Commission created inherent conflicts which incentivised recommendations of commissionpaying products over alternative options. Commission incentivised manufacturers to compete for access to distribution (by flexing the level of commission paid) rather than focussing on product cost and quality. The AIC is therefore a strong supporter of the RDR, particularly its ban on commission payments to IFAs. Since the end of commission in 2012 the investment company sector has seen demand from IFAs start to increase. Before RDR, annual purchases of investment company shares via adviser platforms was relatively steady, at around 200 million per year. They rose to 399 million in In 2015, adviser purchases via platforms amounted to 692 million. A further increase in IFA purchases is expected once the final figures for 2016 are available. These changes in behaviour do represent a real change in the market. They suggest that advisers are more likely to consider investment companies on their merits. That said, it is evident that these purchases are small in comparison with the fund flows in the open-ended sector where purchases are often well over 10 billion a quarter. The RDR is an exemplar of how targeted regulatory reform can enhance competition. The AIC supports maintaining the central elements of the RDR, including removing commission and requiring IFAs to consider a full range of investment products. This should continue to be a foundation of the FCA s efforts to secure effective competition in asset management. The RDR has delivered progress. Nonetheless, the AIC recommends the FCA consider what further steps might be taken to embed and enhance the impact of these reforms. This should include examining if there are barriers to IFAs using investment companies to build diversified, long-term portfolios for their clients. 6

7 Structural advantages of investment companies Investment companies offer a genuine alternative to open-ended funds. Their structural characteristics help them to deliver value for money and strong performance. Independent governance Investment companies have independent boards with company law obligations to promote the success of the company in the interests of its shareholders. This requirement is reinforced by other aspects of regulation. The Listing Rules (LR ) require that the board of an investment company is able to act independently of any appointed manager. These rules set conditions for the independence of the Chairman and a majority of board members (LR A). They require that the board must be in a position to effectively monitor and manage the performance of its key service providers, including any investment manager (LR ). Listed closed-ended funds are also required (LR ) to include in their annual financial report a statement as to whether, in the opinion of the directors, the continued appointment of the investment manager on the terms agreed is in the interests of the company s shareholders. Corporate governance mechanisms identify best practice in relation to oversight of investment managers. For example, the AIC s Code of Corporate Governance (which is endorsed by the Financial Reporting Council) confirms that the primary focus at regular board meetings should be a review of investment performance and associated matters such as gearing, asset allocation, marketing/investor relations, peer group information and industry issues. Among the issues addressed by the AIC s Code is advice that the board should consider the level and method of remuneration of any external investment manager (AIC Code of Corporate Governance, Principle 15). This framework encourages rigorous oversight by boards of the services provided by external investment managers and the level of fees paid. Across the investment company sector as a whole (including companies invested in private equity, property etc. which are not the primary subject of the review) around a third of all investment companies have changed their fee arrangements since This included reductions in basic fees, the introduction of tieredfee arrangements (with lower fees as assets under management increase) and the removal of performance fees (see Investment company costs, below, for a discussion of costs of investment companies with mandates to invest in transferable securities). Boards are also very much concerned with the quality of service provided by managers, the resources devoted to delivering the mandate and the performance of the portfolio against the relevant benchmark (see Performance against benchmarks, below, for a discussion of the record of investment companies with mandates to invest in transferable securities). The scrutiny provided by the board is a key feature of the investment company sector which contributes to its ability to deliver strong investment returns over the long-term. 7

8 Asset management market study The closed-ended structure Investment companies have a fixed number of shares in issue. The number of shares does not change, except when the company undertakes a secondary issue of shares or a specific capital reorganisation, such as a share buy-back or reconstruction. Companies admit their shares to trading on public stock markets. In the normal course of business, investors buy and sell their shares on the market, with no involvement of the company or the asset manager. The level of secondary market trading in the company s own shares has no impact on the funds available to it to invest in its portfolio. In contrast, open-ended funds have a variable capital base. They continually expand and contract the number of units in issue according to the prevailing level of demand. When a greater number of investors purchase units than are selling at that time, the fund manager issues new units. The fund receives new money which is used to expand the investment portfolio. When more investors sell/redeem units in an open-ended fund than are making purchases, the manager has to provide sufficient cash to pay investors. This may mean selling assets to fund redemptions. The fact that investment companies are closed-ended, with no link between the level of trading in its shares and the composition of its underlying portfolio, means that they have certain structural advantages over their open-ended counterparts. Full asset allocation/no cash drag: Open-ended funds often hold a certain amount of cash to allow them to deal with times when levels of redemptions are higher than purchases. This cash holding acts as a buffer so that payments to exiting investors can be managed without the need to sell assets. This means that investors are not getting full exposure to the underlying asset class of the fund. This creates a drag on the performance of the fund s portfolio over the long-term (assuming that the asset allocation is intended to outperform cash). As investment companies do not offer redemptions, they are not required to hold cash to manage this issue. Therefore, there is no drag on their performance. Reduced churn/quality of the portfolio: Open-ended funds faced with high levels of redemptions (for example, in times of high volatility or falling markets) may have to sell assets. This potentially generates transaction costs that would otherwise not be necessary. Costs could be incurred when assets are sold (to meet the fund s need for cash) and when they are repurchased (when money re-enters the fund once demand returns). If trading of the underlying assets is required while the market is experiencing severe falls there is a risk that the quality of the portfolio may be undermined. This situation would arise if higher quality assets (blue-chip, liquid stocks) have to be sold to raise funds. The ability of the manager to pick and choose which shares are sold to raise cash could be influenced by external factors (such as liquidity in the stock) rather than their own preferences to maintain the quality of the portfolio. The requirement to sell assets may therefore affect the overall balance and quality of the portfolio. These issues do not arise for investment companies. Efficient exposure to a wider range of asset classes: Closed-ended investment companies are better able to offer investors direct access to illiquid assets, such as property, infrastructure and private equity. They are not affected by the risk that high levels of redemptions might create a requirement to sell assets at short notice to meet demand 8

9 for redemptions. Were companies forced to sell assets there is a risk that the price received would be depressed. There are examples of open-ended funds being invested in illiquid assets. Open-ended funds that hold physical property have traditionally also held high levels of cash (and/or shares) to help manage the liquidity mismatch between the underlying assets and redemption requirements. Even so, recent volatility in the open-ended property funds sector saw the majority of these funds having to take action (including repricing and prolonged suspension of redemptions) which reflects the problems inherent in holding illiquid assets in these structures. Gearing: Closed-ended investment companies are also able to gear to enhance investment returns. This involves the company borrowing to invest in the expectation that the returns from the portfolio is greater than the cost of the debt. The potential for increased returns is reflected in higher levels of risk. However, these risks should not be overstated. Boards often take a conservative view of gearing. Many investment companies do not use this mechanism. Average gearing across the sector is currently 7%. Even where each of these factors, alone or in combination, only add a small amount to the performance potential of an investment company, over the longer term these advantages can deliver significant benefits for investors. Performance of the investment company sector Investment company management fees The interim report identifies clustering of asset management fees charged to open-ended funds. Specifically, it finds considerable price clustering for active equity funds, with many funds priced at 1% and 0.75% (paragraph 1.20). Investment companies employing external managers show some fee clustering but it is less pronounced than for open-ended funds. Insofar as there is clustering, the level around which fees are grouped tends to be lower than for actively managed comparative open-ended funds. 52% of investment companies have asset management fees set at under 0.75% of assets under management. Only 25% of open-ended funds have asset management fees of under 0.75% of assets under management. Very few investment companies have asset management fees at 0.75% (only 7 out of 158, or 4%). Rather more open-ended funds have asset management fees at 0.75% (520 out of 4889, or 11%). Even fewer investment companies have asset management fees at 1% (3 out of 158, or 2%). Again, more open-ended funds have asset management fees of 1% (619 out of 4889, or 13%). 22% of open-ended funds have asset management fees of 1.5% (or 1081 out of 4889). In stark contrast, no investment companies had asset management fees of 1.5%. 9

10 % of companies/funds Asset management market study The highest asset management fee paid by an investment company (1.74%) is lower than for their open-ended counterparts. 336 actively managed open-ended funds (7%) have asset management fees of over 1.74%, including 126 (3%) at 1.75%. The distribution of asset management fees for actively managed investment companies and open-ended funds is shown in Fig 4. Fig 4: Distribution of investment company and open-ended fund asset management fees (by number) 25% 20% 15% 10% 5% 0% Management fee (% of total assets) Investment companies Open ended companies Only investment companies in sectors comparable to open-ended funds are included. Self-managed investment companies are excluded. Only actively managed open-ended funds are included. The graph shows fees at the end 2016 or, where no 2016 fee details have been published, it shows fees at end Source: Morningstar Asset management fees for investment companies with mandates to invest in shares have been falling since RDR. This is a result of boards responding to increased competition from open-ended funds and, more broadly, a recognition of the increasing importance placed on the level of charges and the impact they can have on investment returns. At the end of 2011, the average (size weighted) management fee for investment companies in sectors with comparable open-ended counterparts was 0.66%. At the end of 2016 the average was 0.43% (a fall of 35%). The figures above reflect the base annual management fee. They do not capture the emerging trend towards tiered fees. Under these arrangements, once the assets under management breach a certain threshold, a lower amount is charged for assets managed over that level. At the end of 2016, 37 investment companies (or 22%) with mandates comparable to open-ended funds investing in traded shares and securities had adopted these 10

11 Management fee (% of total assets) arrangements. This is a significant change which allows these companies to capture economies of scale for their investors. A competitive market, with governance mechanisms focussed on the interests of their investors, is more likely to deliver economies of scale in asset management fees. Investment companies demonstrate this (see Fig 5). Fig 5: Investment company asset management fees vs total assets ,000 1,200 1,400 1,600 1,800 2,000 Total assets ( m) Where the 2016 management fee have not been published, 2015 fees have been used. Self-managed companies are not included. Only companies in sectors comparable to open-ended funds included. Source: Morningstar The chart above excludes three investment companies with assets significantly over 2 billion. The presentation selected arguably gives a fairer picture of the economies of scale currently being captured by the sector. Were the three excluded companies to be included in the data, the analysis would be more positive: that is, the downward trend in fees as scale increases would be more pronounced. Larger companies tend to have more commercial leverage in fee negotiations. They are likely to offer exposure to asset classes (such as the Global sector) which, following RDR, have started to attract more interest from IFAs, who may have a sharper focus than some other purchasers on fund costs. They also tend to attract more attention from self-directed retail investors, who have been influenced by the broader public debate in the media and among policymakers about the impact of charges on returns. These factors are likely to influence the capacity of boards to successfully negotiate lower fees on behalf of their shareholders. 11

12 Asset management market study This is not to suggest that other investors are disinterested in cost. However, they may also pay more attention to other variables, such as asset allocation and performance, which changes their assessment of an investment proposition. Reducing asset management fees in smaller investment companies with more specialist mandates (such as emerging markets) may also be inherently less deliverable. A significant number of investment companies with mandates comparable to open-ended funds have also simplified their asset management fee structures, notably by removing performance fees. The AIC considers that well-structured performance fees can offer good value to shareholders. They have the potential to align managers incentives with those of investors. They can also ensure that high charges are paid only for exceptional performance. It is among the strengths of the sector that boards can consider such arrangements and negotiate the most appropriate fee structure according to the circumstances of the company. The trend for investment companies removing performance fees reflects concerns from some investors that they are difficult to understand. Complexity may be an issue where agreements include claw backs and other mechanisms designed to ensure that these arrangements do not create inappropriate incentives for asset managers or otherwise disadvantage investors. These are competing factors which boards balance when considering how to structure the company s fee arrangements. The AIC has identified 40 investment companies, invested in sectors comparable with openended funds, that have removed performance fees since the start of Again, this demonstrates the capacity of the independent board to actively consider fee arrangements to ensure that they reflect the shareholder interest and broader changes in the commercial and competitive environment. We anticipate that the current trend to revise asset management fee levels and structures will continue into the foreseeable future. Of course, asset management fees are not the only cost which investment company boards oversee. They scrutinise other costs and can also take action to secure value for money for investors. It is also important that there is a balance to be struck between cost cutting and delivering robust systems. It would be unfortunate if pressure to reduce costs, in administration or risk management, for example, had the unintended consequence of increasing investor risks or undermining the integrity of investment products. Performance against benchmarks The FCA s interim report found that both actively managed and passive open-ended funds often underperformed their benchmarks after charges. It is considering remedies targeted on how open-ended funds are governed and promoted to address these matters. However, the FCA s analysis also justifies the AIC s primary recommendation that the FCA should also consider mechanisms to achieve a greater choice of fund structures. This has the capacity to more fundamentally alter the way in which the services of asset managers are provided to the end investor. Creating a market which is less commodified, more diverse, and therefore more competitive, has the potential to raise standards and performance across the board. 12

13 Investment companies operating in equivalent sectors have beaten their benchmarks more frequently than their actively managed open-ended counterparts over 3, 5 and 10 years. Investment companies have beaten their benchmarks more frequently than open-ended funds on both an NAV total return (NAV) and share price (SP) basis over all three time periods. All performance measures (NAV and SP) are on a total return basis, that is, with dividends reinvested. Outperformance is achieved when performance of investment companies and funds is considered by number (Fig 6) and by total of assets under management (Fig 7). Fig 6: Percentage of investment companies and open-ended funds outperforming their benchmark (by number) 70% 60% 50% 40% 30% 20% 10% 0% 3 years 5 years 10 years Investment company SP Investment company NAV Open-ended NAV Source: Morningstar. Data to the end of December Investment company performance has been measured against each company s own specified benchmarks. These benchmarks have been considered and set by the board of the company and are a published performance measure. They provide the yardstick against which investors assess whether or not the company has delivered what it said it would. Performance against these benchmarks is invariably disclosed in annual reports and factsheets. Only actively managed open-ended funds with disclosed benchmarks have been included in this analysis. The track record of investment companies outperforming their open-ended counterparts on a NAV-NAV basis shows the potential for the structure to deliver a stronger performance in the underlying portfolio. The SP-NAV comparison demonstrates the potential of investment companies to deliver higher returns in relation to what investors actually received over the periods considered. 13

14 Asset management market study SP has been stronger than NAV performance in recent years because sector discounts (the difference between the NAV per share and share price, where the NAV is higher than the share price) have tended to narrow. However, the NAV analysis indicates that there is potential for the investment company structure to deliver stronger underlying performance, even where investors do not benefit from lower discounts. Fig 7: Percentage of investment companies and actively managed open-ended funds outperforming their benchmark (by total assets) 80% 70% 60% 50% 40% 30% 20% 10% 0% 3 years 5 years 10 years Investment company SP Investment company NAV Open-ended NAV Source: Morningstar. Data to the end of December Overall these findings are positive for the investment company sector. Investment companies are long-term investments. As might be expected, over the longer term, more companies tend to beat their benchmarks. In this snapshot, the five-year performance data is stronger than the ten-year record. Performance comparison with sister funds A number of investment companies have open-ended sister funds. That is to say, openended funds that have the same manager and investment policy and similar portfolios (greater than 50% overlap). Research by Canaccord Genuity published in October 2016 identified a number of funds on this basis. The analysis below has compared the relative performance of investment companies with their open-ended sisters over five and ten years. The results are striking. The red bars on the charts indicate investment companies which have outperformed their open-ended counterparts. In the substantial majority of cases, it is the investment company structure which has delivered the superior NAV performance. 14

15 Outperformance over 10 years (% p.a.) Outperformance over 5 years (% p.a.) Fig 8: Investment company and open-ended sister funds compared over 5 years 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% Source: Morningstar. Data to the end of December Open-ended fund and investment company performance based on NAV. Fig 9: Investment company and open-ended sister funds compared over 10 years 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% Source: Morningstar. Data to the end of December Open-ended fund and investment company performance based on NAV. 15

16 Outperformance over 5 years (% p.a.) Asset management market study On both a 5 and 10-year basis, the investment company option is most likely to outperform their open-ended sister on a NAV basis (See Fig 8 and Fig 9). Where there is outperformance, the level achieved can be significant. When the comparison is made on the basis of NAV returns for the open-ended sister against share price total return for the investment company, the performance of the investment company sector has been even stronger (See Fig 10 and Fig 11). Over five years the average annualised outperformance was 1.7%. Over 10 years it was 1.1%, with a significant number of investment companies delivering superior performance. Of course, outperformance by an individual investment company in comparison with its sister cannot be guaranteed. Nonetheless, the record is strong. The reasons for the strong performance of investment companies may depend on various factors. This could include full asset allocation, gearing, lower costs (including transaction costs) or more stable exposure to preferred stocks. Whatever the reason, the findings are an indication that the strengths of the structure have been utilised to deliver the best possible outcome for the investor. This analysis gives further weight to the AIC s view that the sector deserves greater consideration by asset managers seeking to deliver strong long-term performance. It should also receive greater consideration from investors and advisers seeking to build a successful long-term portfolio on behalf of their clients (see Primary recommendation, above). Fig 10: Investment company and open-ended sister funds compared over 5 years 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% Source: Morningstar. Data to the end of December Open-ended fund performance based on NAV. Investment company performance based on share price. 16

17 Outperformance over 10 years (% p.a.) Fig 11: Investment company and open-ended sister funds compared over 10 years 5% 4% 3% 2% 1% 0% -1% -2% -3% Source: Morningstar. Data to the end of December Open-ended fund performance based on NAV. Investment company performance based on share price. FCA s proposed remedies The interim report says that any remedies must support different groups of investors using asset management services. The AIC agrees with this view. Any remedies applied must protect the interests of the investment companies (as institutional purchasers of asset management services) and their shareholders (on whose behalf these services are utilised). This must mean: maintaining the ability of investment companies to contract with suppliers as they see fit to deliver their objectives. This should include, for example, maintaining their ability to employ multiple asset managers, separate administrators and other suppliers (such as registrars, corporate brokers, legal and accounting advisers etc.). This position must be maintained without prohibitive compliance burdens. allowing investment companies offered to UK investors to employ non-uk asset managers to supply portfolio management and other investment services. Boards must retain the ability to use the services of managers that they consider best able to deliver the investment objectives of the company. recognising that investment companies are subject to a range of non-fca regulatory obligations. In the investment company context this includes, in particular, company law and accounting standards. 17

18 Asset management market study ensuring that non-uk investment companies do not face inappropriate regulatory barriers when seeking to access to UK markets and consumers. This includes investment companies based in the Channel Islands which have their shares admitted to trading on UK stock markets. recognising that, although the beneficial holders of investment company shares may be retail investors, investment companies themselves contract directly with asset managers (which have no direct contractual relationship with the shareholders). Strengthened duty on asset managers to act in the best interests of investors The interim report identifies concerns that Authorised Fund Managers (AFMs) may not robustly consider value for money for investors. This issue is addressed in the investment company sector as the board of directors oversee the activities of the manager, including ensuring that it provides its services on appropriate terms. The directors have legal duties to act in the best interest of shareholders. Listed companies must report on the continued appointment of the manager on the current terms (see discussion above). The interim report suggests that, if new obligations are to be imposed on AFMs, similar standards of governance should apply to UCITS and AIFs, where the AIFs are distributed to UK retail investors (paragraph 10.13). The AIC considers that high standards already apply to investment companies (which are AIFs). The AIC recommends these existing obligations must be recognised by any remedy that might be imposed on AIFs which are distributed to retail investors. Introducing an all-in fee It would not be a desirable or practical approach to impose an all-in fee on investment companies. The basic mechanism envisaged by the FCA seems to be that, if the set fee level is breached, then the asset management firm would pay the difference out of its own resources. This concept is problematic for the investment company sector. Some investment companies are self-managed. That is to say, they do not employ an external asset manager. Instead they employ their own staff and internal resources to deliver the investment mandate. In this situation there is no fee paid by the company. Even where the investment company operates on an outsourced model the proposal is impractical. Any external asset management firm employed by the company is not responsible for all of its costs. Expenses including the cost of the registrar, corporate broker, depositary, accounting and audit advice are incurred directly by the company itself. The external manager is not responsible for these service providers. They contract with the company, which pays them directly. Some investment companies employ more than one external supplier to manage different parts of the portfolio. For example, different firms may be employed to manage assets in different geographic regions. Imposing an all-in fee to an external manager of an investment company does not create a mechanism for investors to identify what is being taken from the fund (which is the intention of the proposal). 18

19 Applying an all-in fee directly to an investment company would also be impractical because there is no separate pool of resources available to be transferred to shareholders were the threshold to be breached. The company s assets are already attributable to shareholders. Aside from the specific issues arising from the investment company structure, there are also risks in creating financial incentives for asset managers to manage the level of trading to ensure that an artificial cap is not breached. This threat is arguably lower in an investment company context (as there is no need to sell investments to meet redemption demands and because the board would monitor this risk). However, creating incentives of this nature could make it more difficult for investment company boards to hold the manager to account and ensure that optimum performance is delivered. Notwithstanding that this remedy is currently only being discussed for funds invested in transferable securities, the negative impact of cost caps might be particularly significant for assets such as property, private equity, venture capital and infrastructure. There is no ready market for these assets. Transactions in these investments often involve specific due diligence, legal and other services. These costs can be highly variable. It is particularly difficult to see how an all-in fee would work in this context. Measures to help investors identify which fund is right for them Investment companies make extensive disclosures that allow investors to understand their investment objectives and how the company s portfolio has performed. Where they are listed on UK markets, for example, they are required to publish an investment policy (LR ) setting out their approach to asset allocation, risk diversification, and gearing. This includes setting maximum exposures. This information gives investors insight into what the company is aiming to achieve. Indeed, the rules require that the disclosure should be sufficiently clear and precise to allow investors to assess the investment opportunity and identify how risk spreading is to be achieved. The disclosure is also intended to ensure that investors can assess the implications of any proposed change in the investment policy. It also has wider implications for the operation of the company. The company must manage its assets in accordance with its published investment policy. If the company wishes to change this policy in a material way it must secure shareholder approval. Under the Non-Financial Reporting Directive all companies with their shares admitted to trading on regulated markets have to make an annual disclosure in the annual report and accounts about the performance of the business. In the case of an investment company this means explaining the performance of the portfolio and providing an analysis of how it has performed. From the start of 2018 the PRIIPs regulation will require a Key Information Document (KID) to be provided in relation to each class of share issued by an investment company. This will include disclosures designed to give investors an indication of possible performance, costs and risks. 19

20 Asset management market study The investment company sector is characterised by very high levels of disclosure regarding the objectives of the company and how it has performed. This transparency is a strength of the sector. The AIC is unconvinced that additional benefits would be secured by imposing additional disclosure obligations on the investment company sector. The AIC recommends that no additional disclosure obligations be imposed on investment companies. Communication of charges at point of sale and in ongoing communications Investment company shares are PRIIPs. From 2018 retail investors purchasing investment company shares will receive a KID at the point of sale. This will include information on charges, in both monetary (i.e. pounds and pence) and percentage terms. Where a PRIIPs KID is being provided the AIC recommends that the FCA should not require any additional cost disclosures at the point of sale. To do so would be disproportionate and potentially confusing to investors. After the UK s withdrawal from the EU, the FCA might chose to amend pre-sale disclosures to make them more useful to investors. The AIC recommends reviewing the impact of PRIIPs KIDs following Brexit to determine if changes would be helpful. Once MiFID II has been introduced, additional disclosure of the costs of investment will be provided on a periodic (annual) basis. The AIC has reservations about creating further pre-sale disclosure requirements. The FCA s research indicates that current disclosures are only used by 25% of investors when selecting funds. It is difficult to conclude that simply increasing the amount of disclosure will have an impact on the market. The risk is that it will create additional compliance burdens for companies while remaining unused by many investors. This is not to dismiss the value of pre-sale disclosure. This information is used by some investors. It may inform the views of intermediaries, such as IFAs and discretionary wealth managers as well opinion formers, such as the media. These users have the potential to take a view on issues such as cost and performance, which can have a knock-on effect on competition in the broader market. Transparency and standardisation of costs information for institutional investors Directors of investment companies have not expressed concerns to the AIC that they are unable to secure sufficient information on costs and charges. They have not suggested that they do not have adequate information on transaction costs. Indeed, the extent of these costs would customarily be set out in the audited annual report and accounts. The interim report suggests that a standard disclosure format might be developed. This is an issue being explored by the Investment Association. This initiative may be helpful for some institutional investors, such as pension fund trustees, which are identified as having difficulties in securing the information they require. The benefits to investment company boards are less obvious. In principle, the AIC does not object to exploring this option. However, it would be a concern if a standardised template made it more difficult for institutional investors to secure specific information which may be more relevant to their particular circumstances. 20