The asset management sector in the UK is very competitive, but not very price competitive. This apparent paradox runs through the FCA’s report on asset management, but is never adequately recognised or explained. But only by acknowledging it can regulators help to create an industry which works better for investors and for the economy as a whole.
In a modern economy, most products, including the services of asset managers, are complex and multidimensional. Whenever this complexity is found, producers will focus on those aspects of their products that are salient to their customers. In recent decades this selective focus has facilitated abuse of consumers. Cheap printers need refilling with costly cartridges, and energy firms and mobile phone companies offer appealing tariffs which turn out to be more expensive than you think.The sticker price of the car is low, but once you are engaged you discover that it is inflated by extras you cannot do without and overpriced spare parts.
And yet the FCA – and the Competition and Markets Authority, which effectively sets the guidelines within which the FCA assesses competition – are in the grip of a facile model of competition based on a theory of rational economic man – always man. The approach emphasises the three A’s of consumer choice. Before making a purchase, rational economic man must access – obtain the information he needs; then he will assess – appraise that information in careful and considered fashion; and finally act on the basis of this process of extended scrutiny.
Of course, real people are watching Netflix, making supper, and using their smartphones to keep in touch with their friends. In the meantime, those who work in the always-expanding compliance departments of asset management firms are burning the midnight oil preparing for the latest European acronym – PRIIPS. They are refining key information documents which, as the FCA’s own research shows, are opened by almost nobody at all. We should not be bemoaning this lack of customer engagement, but rejoicing that the population mostly has better things to do.
Asset management is one of a group of products – like brain surgery and estate agency – which are not very price competitive because quality is hard to judge, particularly in advance, and it is worth paying a lot more for an outcome that is better. Some brain surgeons earn a lot – and note well that brain surgeons earn more in a competitive market, such as the United States, than in a monopolistic ones such as the United Kingdom – because it is not easy to become a brain surgeon: and estate agents charge a lot, although estate agency is not especially profitable, because anyone can rent a high street frontage and put up a sign saying ‘estate agent’. The potential profits from selling houses are driven down by the proliferation of agents who sell only a few properties a year.
Asset management lies somewhere between brain surgery and estate agency. There are few barriers to entry, but fixed costs are such that it is difficult to prosper without achieving minimum scale. Still, the ineffectiveness of price competition in active management means that, although larger managers have lower costs as a proportion of assets under management, they enjoy the benefit through higher margins rather than gaining further market share. So despite the advantages of size, concentration in active management is not too high. And consequently overall asset management profitability is high – especially if you add back the substantial share of profit that is paid to senior employees.
The element of the asset management product that is salient to both institutional and retail investors is the promise of future performance, and asset managers therefore focus their marketing on their past performance. They know their potential customers have not read – why would they have read? – the research whose findings the FCA has painstakingly confirmed; a wide range of studies now show – perhaps counterintuitively, because it is not true of brain surgery or estate agency – that in asset management past performance conveys very little information about the future.
Greater transparency of charges will do little harm, but will also make little difference. Those customers who do focus on price are sensibly migrating to passive funds. In that segment price competition has intensified and scale economies are concentrating funds into the hands of a few very large managers. More and more complete information may lead to some resistance to the overall level of charges, And perhaps a better appreciation of compound interest will help investors understand how small differences in charges can have a large impact on the ultimate size of their savings pot. Perhaps.
The FCA report gropes towards the right solution for the active sector, but you have to work hard to extract it from the report, and some of the report’s recommendations actually get in the way, such as the ‘comply or explain’ insistence on adherence to benchmarks. Asset managers should differentiate themselves, not by spurious promises of risk-adjusted outperformance relative to some broadly based benchmark, but by proclaiming their distinctive philosophy and style. And the question ‘what are the unique characteristics of your asset management approach?’ should be the principal topic of discussion at the beauty parades conducted by and for institutional investors and financial intermediaries. Only in this way will competition work as it should in this industry; as a selection process that favours asset managers who generate long-term returns for investors by deep and distinctive understanding of the underlying investments.
This is an expanded version of an article first published in the Financial Times on June 30th 2017.