Transparency matters

Accusations of deception, opacity and misinformation are being pointed at the fund management community. Investment Management Association chief executive Daniel Godfrey wants reforms that will put the industry on the front foot. Interview by John Greenwood

Auto-enrolment has moved the scrutiny of investment fund charges up a gear and some stakeholders are not liking what they see. Research paid for through bundled execution costs, cash for access to senior management claims, money lost through spreads and questions over revenues from stock lending all have the potential to paint the asset management industry in a bad light. For IMA chief executive Daniel Godfrey, reforms that will make fund managers’ charges more transparent are essential if confidence and trust are to be restored.

Central to the charges being put to the fund management industry is the concern that neither the AMC nor even the TER reflect the true cost being levied by fund managers for the expertise they bring to a fund. At a recent IMA event Frost Consulting said $22bn is being raised globally for fund research and corporate access by asset managers opting to trade shares on a more expensive bundled basis rather than taking the cheaper execution only option, allowing this cost to not appear in AMCs or TERs.

“There is a total cost involved in managing a fund, some of which is being spent in dealing commissions, some of which is coming back by way of research. If it wasn’t being done that way, would it mean the cost would come down, or would it mean the cost would have to be recouped by the asset manager in a different way, by increasing AMC to cover it?” says Godfrey, who also accepts that the opacity of the current system is not ideal.

“There are potential cross-subsidy issues with the current system, and that is why we are looking at it. But I don’t think it is quite as simple as saying that this is money that would not be being spent by you,” he says.

Godfrey does not believe cross subsidies exist where fund managers spend more of their research pot on funds they want to do well than on ones they are less bothered about. “It would be more in the nature of having a fund that is benefitting hugely from the research provided by one broker and another one that we don’t rate that research so much. So is there a cross-subsidy taking place. What you would expect, and fund managers work very hard to do this, is that they would allocate those commissions to the research where they get the value for the particular fund. But it is not a perfect system,” he says.

In July the IMA launched a consultation on its Statement of Recognised Practice, or Sorp, for fund charge accounting. As well as calling for a pounds, shillings and pence way of showing charges, it for the first time asks for the amount raised by a fund for research through bundled commissions to be published, something that until now the overwhelming majority of fund managers have refused to disclose, even though the figure reflects the extent to which they have been spending their clients’ money.

Disclosing this figure has been seen as a welcome step in the right direction. But some critics, such as the True and Fair Campaign, argue that if a fund manager wants research it should pay for it out of its AMC, particularly as the research money has nothing to do with the shares that are bought. Why not buy shares as cheaply as possible and then spend money out of the P&L account where appropriate and reflect that in the AMC or TER of the particular fund?

“That is what our project into charges is set to answer. But the one word I would take issue with is that ‘surely’ research should be within the AMC. There is an agreement between the fund manager and the fund – a legal agreement, very detailed, that is governed by FCA regulation – and in the case of funds where the dealing commission is paid for by the fund there is a written agreement between the parties that the fund will bear the cost of dealing commission and that it can be used to buy research. So you can’t say ‘surely’. It may be that you think that is a better way of doing it, but there is a legal agreement that says it doesn’t,” says Godfrey.

But even if regulations allow research to be paid for out of broker commissions, what about at a common law contractual level? If the man on the Clapham omnibus believes that the AMC is the payment to the fund manager for its intellectual expertise, including its research capabilities, and the fund manager does nothing to dissuade him that this is the case, then would not the current system seem to operate in a way that means consumers’ expectations are not met?

“If you are asking me whether I think that it is understandable that many consumers would be surprised that sell-side research was being paid for on top of the AMC, the answer is yes.
“But I have to be fair to everyone in this and the rules allow it, and its in the prospectus and report and accounts. The numbers aren’t in the report and account, but the fact that it is deducted is. My view is the more transparency the better, and that is why these numbers would be included in our inclusive schedule of costs.”

Godfrey believes the complexity of charging extends way beyond the fund management industry and argues that life offices’ structures also create complexity. This, one could argue, means the OFT will have its hands full trying to define what charges are actually being levied in DC pensions.

“It depends on the underlying structure of the fund. Where it is a life company fund it is going to be very different. The short difference between the life company fund and the Ucits fund is that the life company fund is on the balance sheet of the company. So the disaggregation of things like the transaction costs into a specific unit series is very difficult to disentangle. What the IMA is doing with our Ucits funds could become a building block for this.

“Say the life fund held units in a Ucits fund. The life fund could calculate the average number of units it had held in the Ucits fund over the course of the year. So lets say our Ucits fund says each unit bore a cost of 5p, excluding spread. The life company says I can work out how many units I held over the course of the year, and multiply it by the number held by the client and say, that cost you £42. For the platforms, they might be able to do it. Whether that would work for a pensions default fund, I don’t know. It will be easier where it is invested directly in a Ucits. And we are working with other bodies on this.”

Could Godfrey envisage a situation where auto-enrolment default funds are not allowed to trade with research bundled in?

“I doubt it, for two reasons. The project we are doing at the moment is looking at whether there is a benefit to the current structure that makes it worth having the opacity. So if at the end we have identified reasons we can articulate clearly that these are the benefits for consumers that would be lost, that will apply to everyone, whether they are in a default fund or anything else.
“If there is a case for keeping the status quo, then no. And if there isn’t, you have to change it across the board. I don’t see a future where auto-enrolled schemes have a different structure by regulation.

“It is not inconceivable that clients might say we will only do this if you will operate in this way. At which point the manager might say that is going to be too complicated for me, so we are out. Or they might say, yes, we can do this, but we might have to pay a little more than they would otherwise be,” he adds.

Critics of the current system argue that the sell side have created a system where it creates a pile of money – $22bn a year globally in 2011 – that can only be spent on research, much of which is created by itself. Last November’s FSA paper on conflicts of interest in the asset management industry raised concerns that the controls on the spending of money for research raised through commissions were not as rigorous as those on money spent out of a fund manager’s own profit and loss account.

“That is a valid point but by the same token if you take it to an extreme you might say there is one analyst who is generating $21bn worth of value because her valuations are so incredible, and no-one else is adding any value. So if you are paying a market price, the cost to the market is the same but it is all going to the same person. So that is where the cross subsidy could come in,” he says.

Should analysts be concerned that in future they may potentially be less money going their way?

“Yes there is a place for analysts but like everyone in life they should have a value proposition and deliver on it. It could even be that if the market was more market-based there might even be more analysts, and more money might be spent. But you would know it was being added for the value of the beneficiaries,” he adds.

Godfrey is clear whose money returns on stock lending is. “There is a slight misunderstanding about stock lending – The European Securities and Markets Authority came out with some guidance in February that all fees generated from stock lending should go to the client, other than reasonable fees incurred in generating those returns. You just have to believe those fees are reasonable because the regulator is going to come and ask you. I don’t believe there is any egregious practice going on, if you are deducting 50 per cent from the stock lending and everyone else is only doing 10 per cent, people are going to ask questions.

“Or you might say we have invested in market-leading capacity to generate the best fees from stock-lending and it is very expensive, but the return is better,” he says.

Dealing with the effect of spreads on returns is a more complex matter, however.

“Spreads are identified through our enhanced disclosure guide. But spread itself is an implicit cost rather than a moment in time at which you spend some money. So in terms of accounting to customers, we don’t include a figure. You see it in two ways – the frictional drag caused by buying and selling shares shows up in performance. But we also have some figures in the enhanced disclosure guide that can help. 

“And we can probably go further as well – the first step there would be to get a common understanding of what portfolio turnover is. You would think that would be easy. I want to boil it down into a pounds and pence figure that looks historically at what it has cost you to be in a fund. But we should be looking at what is a portfolio turnover rate. So if you are buying new stocks because you have money coming in, that isn’t really telling you how active the manager is in trading,” he says.

The thought of Labour getting in power and introducing root and branch reforms is not on his agenda, although he clearly wants to get the industry into a better place so it can earn the right to shape its own future.

“That is not really what I am thinking about at the moment. I am thinking about how the industry can identify what the right thing to do is an do it because it’s the right thing to do and not because someone has opened a can of worms. We can do that whoever is in power and if that is genuinely what we are doing then we have a compelling case for any colour of government to let us get on with it,” he says.

Such fundamental changes are likely to impact some of his members considerably more than others, but he reports full backing for the reform programme he is leading.
“Are there one or two constant objectors to the idea of reform? No. Is there anything that has had a lot of people saying they don’t like it? Also no. We have had sensible technical pushback on some issues. But broadly speaking people are very much aligned with the IMA’s purpose statement, which is that what we are all here for is to do very important things for real people and the economy.

“There are huge opportunities for UK asset managers in the future, but you have got to be around. And the best way to make sure we are still around is by doing this for ourselves.”