The new interim report from the Financial Conduct Authority is almost scathing in its critique of investment consultants and the value they provide to the asset owners they are meant to serve.
Their extensive and detailed analysis was almost buried beneath even more provocative pronouncements on active versus passive management, which front-loaded the same paper and dominated last week’s headlines. Yet its implications may be even more far-reaching, potentially opening the door to greater scrutiny and even regulation for the consulting industry in the UK.
Consultants should not run shy of these criticisms and concerns. Many of them are not only substantially valid but deeply relevant, not just to pension funds in the UK but globally.
For the largest operators in the marketplace, asset allocation advice dominates the business model, fundamentally underpinning the relationship between consultant and investor, driving revenues in a host of related services that run down the implementation chain and elsewhere. Yet the report observes that “institutional investors struggle to monitor and assess the performance of the advice they receive” on asset allocation and investment strategy. In other words, firms are not assessing the part of their service that still – despite the increasing weight of implementation risk relative to allocation risk during the past decade – represents the most important contributor to client outcomes.
Of course there are obstacles to fair assessment, since allocation decisions are ultimately owned by the investor. Yet, surely, it is an area where greater analysis, transparency and comparability would indeed be feasible. In an industry where performance is not evident, brand becomes king and switch rates – the frequency with which an institution will change its consultant – are remarkably low, as the FCA observes. In the short term, this may seem rather positive from a consultant perspective: why facilitate scrutiny when that scrutiny may drive competition? Yet self-interest is not well-served in the long run by fostering an uncompetitive marketplace.
My own firm (bfinance) is not involved in offering asset allocation advice. We have no self-interested angle on this subject. Yet, speaking from the perspective of a niche investment consultant, the health of the industry – not to mention investors’ and regulators’ faith in it – concerns us all.
A second strong criticism strikes somewhat closer to home. The paper is – if anything – even more brutal in assessing consultants’ activities as a gatekeeper between allocators and fund managers. Not only does the FCA’s analysis reveal that managers in receipt of high ratings from all major consultants do not outperform those who scored less well; their econometric analysis demonstrates the “large and statistically significant effect” that these buy-lists have on flows to institutional investment products.
It is already widely recognised that ratings systems do not incorporate a significant portion of potential products: getting onto a buy-list requires time and money, as evidenced by “the large proportion of asset managers’ institutional marketing budget which is spent on building relationships with investment consultants.” It also requires the manager to have sufficient capacity to make the consultant’s own resources worthwhile – a particularly significant restraint in niche sectors and private asset classes. Yet the FCA report phrases the problem even more strongly. “Consultants’ ratings,” it says, “act as a barrier to entry, expansion and innovation.” It is a serious conclusion.
Indeed, the regulator appears to believe that consultants should not only maximise industry competitiveness in terms of available products but also in terms of fees, saying: “Consultants do not appear to drive significant price competition between asset managers.” Cost, indeed, is a central theme of the entire report, including its substantial analysis of the active management industry as a whole.
How much more influence could be exerted by the key gateholders on these fees? Perhaps not as much as the FCA hopes, particularly when managers on buy-lists will already be enjoying the fruits of those enhanced inflows and hardly feeling the pressure to undercut each other or scrap for business.
The industry should not attempt to be defensive or dismissive on these points. Rather, it should focus on how to advance the FCA’s key themes as expressed here: boosting transparency and fostering healthy competition. We can openly demonstrate our progress in connecting investors with hard-to-reach, capacity-constrained managers, particularly in alternative asset classes where manager performance – being far more widely dispersed – has a far greater influence on portfolio outcomes. We can offer greater openness on final negotiated prices, not proposed fees. We can work to open the door to more managers, regardless of what they’re able spend on us before they even win a penny of business. We can publish research that provides all asset owners – not just our own clients – with information advantage and negotiating power in an industry where buyers are frequently at an information disadvantage. We can even take steps to facilitate greater competition between ourselves. We can, and we should.
Kathryn Saklatvala is global content director at bfinance