Higher interest rates following increases in the Bank of England “Bank Rate” means yieldson cash are attractive once again.  There are different ways to access cash yields: bank deposits, platform cash and moneymarket funds each have advantages and disadvantages.  Minimising frictional costs, and maximising flexibility is key when developing a cashmanagement strategy, in our view.
In this research note for our clients, we explore the role of money market funds in providing a low risk platform-based Investment with a yield similar to Bank of England rates.
Further reading:
Read our October 2021 comparison of money market funds and fixed time deposits

[5 min read, open as pdf]

• Creates new principle and four key outcomes
• Builds on TCF and PROD rules for advisers
• New rules kick in from 31st July 2023

The FCA has now issued its Policy Statements and Finalised Guidance on Consumer Duty.  From 31st July 2023, the new rules will come into force for existing products and services.  From 31st July 2024, the new rules will come into force for legacy products and services.
The rules create a new Consumer Principle that requires firms to deliver good outcomes for consumers by “acting in good faith, avoiding cause of foreseeable harm, and enabling and supporting retail customers to pursue their financial objectives”.
Read the full article

[7 min read, open link]

• FCA has published the new rules on Consumer Duty
• This will impact how investment products are designed and distributed
• The new rules come into effect from 31st July 2023

In this article for FT Adviser, we explore how the new Consumer Duty rules will impact the design on investment products by providers.

Read the article on FT Adviser

As an investment consultant, a lot of what we do for financial advisers & DFMs we work with is to use our research & development capabilities across Portfolios, Fund & Indices to support our clients' own "proposition development", that goes beyond just portfolio design.

So we were delighted that both our Custom Portfolios solution for advisers - with Elston Portfolio Management - and our Liquid Real Assets Index strategy for inflation protection were "Highly Commended" in the "Best Proposition Development - Overall" Category at the 2022 Investment Week Innovation & Marketing Awards against some very well respected colleagues and providers!

We were also very happy to be a Finalist in the "Best Thought Leadership - Retail" category for our extensive CISI-endorsed CPD webinar programme.

We would be delighted to work with UK advisers to support your investment proposition, please get in touch if you would like an initial consultation.

[7 min read, open as pdf]

Fee pressure is here to stay.  In the “race to the client” being run by platforms, DFMs and fund houses, it’s up to advisers to rethink their business model, and make sure they stay in the lead.
​
In this series of articles, I look at some of the key topics explored in my book “How to Invest With Exchange Traded Funds” that also underpin the portfolio design work Elston does for financial advisers.

Fee pressure is here to stay
Between competition, regulation and ultra-low interest rates, there is understandable and justified pressure on costs.

Looking at the overall “value chain” – the cost of advice, platform, discretionary manager, and underlying funds – means that without careful scrutiny, investing a pension or an ISA ends up meaning its client money risked for the financial service industry’s reward.

With these “all-in” costs sometimes as high as 2.50%-3.00%, the situation is untenable, particularly when contrasted with non-advised workplace pensions and non-advised d2c solutions that can deliver a manager multi-asset investment solution at an all-in (excluding advice) cost of 0.50-0.75%.

Put simply, if we imagine a price anchor/price cap of 0.75% for workplace and pathway-style non-advised investments, there is effectively a soft-price cap of 1.75% for advised investments, in our view, from a Value for Money perspective.

MiFID II has been a tremendous driver of total cost transparency, and has sharpened the minds, and the pencils, of clients and advisers alike.
​
The cost of delivering investment solutions (excluding advice) differs vastly depending on whether accessed via advised, workplace and non-advised channels (see Fig.1.).  This is not sustainable.

Changing landscape
Given the inevitability of fee pressure and a steadily shrinking pie, there are three key trends emerging:

• The race to the client: the only part of the value chain that is non-commoditisable is client relationships.  Either having them, or not.  This is driving a huge surge in M&A activity and vertical integration and business transformation, as platforms set up DFM businesses, DFMs offer advisory services, and fund houses go direct to client.  In this race to the client, advisers are in the lead, but will have to fight to keep it that way.
• Control of the Value Chain is key: "whoso looketh after the client, controlleth the value chain".  Next generation advisers are using their muscle to be price setters to platforms, DFMs, and funds not price takers.
• The institutionalisation of retail: As technology makes platforms and investment management more efficient, the boundaries between institutional and retail investment solutions and pricing has started to blur.

 
The Race to the Client
Sustained fee compression across the value chain, means that there is a growing awareness amongst providers within the industry that their position in the value chain can be commoditised.

That’s why there is so much corporate activity and proposition change from all the different parties within the value chain. Fund houses are investing in platforms, platforms are setting up advice firms, and advice firms are setting up DFMs.

All of these parties are afraid of watching their products or services being commoditised, and hence many want to move to a vertically integrated model. I call this the “Race to the Client”.

And yet at the end of the day, there is only relationship that matters and that cannot be commoditised. And that’s one of trust and personality which makes up the relationship between the adviser and their client.

Control of the value chain: who has the power?
Whilst some fund houes see advisers as “Distributors”, the truth is now the opposite.  Instead of being price takers, advisers are becoming price setters.  In the race to the client, advisers are and should aim to stay in the lead. But only if they take control of the value chain and align it to their clients’ best interests.

Next generation advisers are no longer fund pickers, or model pickers, or manager pickers: they are fiduciaries who owe a duty of care to their clients and help them navigate the maze of financial services to ensure good customer outcomes, and excellent value for money.

The institutionalisation of retail
As workplace schemes become more individualised, and individual schemes become more mass-market, the retail and institutional worlds are beginning to collide, and this “institutionalisation of retail” means a focus on greater governance, increased professionalism, at substantially lower end-client costs.

Strategic options for advisers
Advisers have a number of options to compress all-in costs, whilst enhancing their business model.

• Option 1: reduce your advice fees from 1.00% to 0.75%, 0.50% or even 0.25%?  Erm, no.  That would be misplaced, as out of all parts of the value chain, the value of advice as well as the time-cost in delivering it, is highest.  But amazingly, in the absence of thinking through alternatives, some advisers do take this approach.
• Option 2: leverage your scale and the competition in the platform market to use a lower cost platform.  With little to differentiate platforms, their pricing power is weak, and susceptible to commoditisation, particularly from more technology enabled disrupters..
• Option 3: leverage your scale and the competition in the DFM market to use a lower cost investment solution, both in terms of the DFM fee and the underlying fund fees.
• Option 4: a combination of Options 2 & 3.  But with a twist: by creating your “own” proposition you can ensure you have ongoing and permanent control of the overall value chain, to ensure you can protect client’s interest by leveraging your scale to plug and play the right manager and/or platform for your mandate.  This is not a loss of independence, but using your clients’ aggregate scale to obtain best terms from suppliers.

If Option 4 can be done with a recalibration of business focus to devote time and energy to new business and excellent, empathetic client service, then so much the better.

Stop feeding the hand that will bite you
The race to the client is hotting up, and is all too visible from the M&A activity in the sector, and the rush of private equity capital into the UK advice market. 
And yet many adviser firms seem determined to feed the hand that’s going to bite them.
Why use a DFM whose stated aim is to cut you out of the value chain, and who spends more on Facebook ads, than your entire turnover?
Why use a fund house whose billboards at every station reach out to your clients to go direct?
Why use a platform that prefers to offer accounts to customers directly?
Looking after clients is the most valuable part of an adviser business.  Don’t give them away to your larger, bigger branded competitors.

Summary
As the race to the client hots up, the good news for advisers is that you are already in the lead.  So stop feeding your competitors – the DFMs, the fund houses, the platforms, and take back control of the value chain to ensure you can protect clients’ best interests.

© Elston Consulting Limited All Rights Reserved

• A recent ruling implies that VAT on DFM services is not always applicable
• Differentiating between the types of service is important
• Owing to consequent impact on advice fees, additional clarity is needed

A recent ruling on DFM fees implied that VAT is not chargeable on intermediated Model Portfolio Service offered by a DFM.
This throws into question when is VAT chargeable on DFM services and when isn’t it, and how, if at all, does it impact the VAT on advice.
Whilst we are not tax lawyers, we try and disentangle the guidance as it stands today and what the recent ruling could mean, to help frame the right questions rather than provide definitive answers.
First of all we need to break DFM services into 3 parts:

• Non-intermediated Direct DFM service
• Intermediated Direct DFM service
• Intermediated MPS service

​Non-intermediated Direct DFM service
Where DFMs contract directly with clients to manage portfolios either on an advisory basis (seeking confirmation with client), or on discretionary basis (investing as the manager sees fit, for pre-agreed mandate), the VAT position seems clear-cut.  The DFM fees are VAT-able.  See HMRC manual VATFIN5800 for more information.  Fund/security dealing commissions are VAT exempt where charged separately.  If charged within a bundled “all-in” fee, the whole fee is VAT-able.
For intermediated DFM fees, we have to consider two different types of DFM relationships – direct DFM (where DFM contracts with client directly to manage a portfolio in its custody), and platform-based MPS (where DFM contracts with platform to manage investments, and advisers “link” clients to that model).

Intermediated Direct DFM service
Where advisers introduce and monitors a “direct DFM” relationship – where the client contracts directly with the manager (albeit with the adviser’s involvement and fees are referenced in the contract), the VAT position is likely to be the same as above.  Namely VAT on the DFM fee is chargeable.  This is because the manager is providing a service directly to the client.  Both the adviser and the manager have separate direct contractual relationships with the client.  Importantly, because the adviser is introducing the client to a VAT-able service, the advice fees in relation to “direct DFM” services are also potentially VAT-able.  See HMRC manual VATFIN7600 for more information.

Intermediated MPS service
Where advisers recommend and oversee a platform-based model portfolio service (MPS), the adviser’s fee may not be VAT-able, as it is an intermediation of a non-VATable service (the platform). 
The primary service the platform supplies in return for such fees (however comprised) are made up of the following functions:

• The aggregation of the investors’ capital to bulk purchase securities in funds and other investment products;
• The recording of the transactions and holdings;
• The holding of the investments in trust as nominee; and
• The disaggregation of the income from the holdings, including realisation of the assets, in accordance with the individual beneficiaries’ investments.

These services are VAT exempt.
HMRC’s position has been that charges for additional platform-based services, such as portfolio management services would be liable to VAT under VIN5800 above.
However, although the details of the Tatton case are not public, it’s possible that Tatton sought to differentiate MPS service from direct-to-client DFM service and position it more as a quasi “fund” rather than an individual service.
Under VAT5800, there is a clear exemption for the management of Specialist Investment Funds, such as authorised unit trusts and OEICs.  This is outlined in more detail in VATFIN5100
If MPS can be viewed more like a “fund”, then it’s possible that model portfolios of funds could be added to this list of exemptions.

Who does this ruling benefit?
If this change is confirmed in guidance (rather than on a case-by-case basis), and other MPS-based DFMs can obtain similar refund, then it will be for those DFMs to decide whether to return those fees to clients.  As Tatton was clear that it’s fee was gross, and any VAT costs were absorbed, it’s fair enough for Tatton to retain the refund – it took that risk and won.  For DFMs that have specifically charged for VAT additionally, then expectations may be different.
As well as providing good news for platform-based DFMs and their end-clients, any potential VAT exemption on MPS services is also good news for advisers that rely on an intermediation exemption from VAT on adviser fees. 
Some advisers fear that intermediating VAT-able DFM services on platform could potentially require them to charge VAT too.
By intermediating a non-VAT-able MPS service, those advisers’ fees remain clearly non VAT-able.

VAT and the value chain
The only – broader – question remaining is that if the whole value chain – advice, platform, DFM MPS and underlying funds are relying on complex and potentially conflicting VAT exemptions, then there is a broader policy questions as to whether, when and why should VAT be paid on the advice and/or management of client’s investments, at some stage in the value chain.
If the answer is no, never, that’s good news for the industry and clients alike, but I can’t believe that HMRC will be so knowingly or unknowingly generous for too long.

Clarity needed
Whilst HMRC won’t comment on individual cases, some further – clearer – guidance would be welcome.

For clarity on this point, advisers should seek information from platform-based DFMs as regards their VAT status.

DFMs should seek legal advice before revising their charging structure, and, if necessary, obtain case-specific guidance from HMRC.

However given the gaps in the published guidance from HMRC, as outlined above – it would be helpful if their guidance could be tightened up too as MPS services are not explicitly referenced in guidance anywhere, which has allowed uncertainty to prevail. 

• Create a structured, systematic and evidenced-based investment process
• Don’t reinvent each wheel, but blend institutional-quality expertise
• Remain agile and adaptive as implementation options evolve

What actually delivers performance?
A portfolio’s asset allocation is the key determinant of portfolio outcomes and the main driver of portfolio risk and return. Ensuring the asset allocation is aligned to an appropriate objective is therefore key. Getting and keeping the asset allocation on track for the given objectives and constraints is how portfolio managers can add most value for their clients.

What differentiates portfolio managers?
There are no “secrets” to asset allocation in portfolio management. It is perhaps one of the most well-studied and researched fields of finance.

Perhaps unusually for a competitive service industry, core know-how is not a barrier to entry. Anyone completing their Chartered Financial Analyst exam will have a comprehensive grounding in the principles of portfolio management.

There are, in my view, three differentiating factors for discretionary fund managers.

1. Quality of Process: how that know-how is deployed and implemented: the quality of design, research, implementation and risk control
2. Quality of People: how that know-how is explained and communicated to clients: the quality of brand, personalities and client service
3. Quality of Proposition: how that know-how adapts to changing research, tools and technologies

Quality of Process
To create a quality investment process, managers need a robust set of capital market assumptions for each asset class and the relationship between asset classes. Ideally these should be term-dependent, to align to an appropriate term-dependent investment objective.

To create an appropriate asset allocation, managers need to consider what their objective is: is it risk-adjusted returns in which an asset-optimised approach makes sense (the bulk of retail multi-asset strategies take this approach); is it to match future liabilities, in which case a liability-relative approach makes sense (more akin to how a defined benefit pension scheme is managed); is to target a volatility level or band; or is to target a level of income distribution.

Managers also need to design a set of constraints – risk budget, fee budget, minimum and maximum position sizes, portfolio turnover constraints and counterparty considerations.

Managers need to make implementation decisions as regards how they access particular asset classes or exposures – with direct securities, higher cost active/non-index funds, or lower cost passive/index funds and ETFs. Fund level due diligence as regards underlying holdings, concentrations, round-trip dealing costs and internal and external fund liquidity profiles are key in this respect.

Quality of People
Whilst we believe strongly in the deployment of technology to assist managers in designing, building and managing portfolios, that doesn’t mean that people aren’t core to a business. Investment managers must invest in their people to build on both quantitative skills that are necessary to finance as well as communication skills that are necessary to communicate with advisers and their clients. It’s people that make up a brand, and clients measure performance as much on client service as on returns.

Quality of Proposition
There are few firms, if any, that can build an end-to-end proposition entirely in-house.  Part of a manager’s skillset is to understand where their expertise lies. We believe that there is little value in reinventing the various wheels of a proposition. But there is tremendous value in bringing together best in class components that create a proposition in a way that is robust, repeatable and proprietary.

It’s the quality of choices around proposition that differentiate portfolio managers, and in this respect it is important to remain agile and adaptive, to a rapidly changing landscape in asset management and technology.

Bringing it all together
The objective for investment managers is no longer about “pushing” one product or another. It should be about providing solutions that help address a specific need.
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Managers should ask themselves: what problem is the investment strategy trying to solve for their client? How can they do that in a way that is robust, repeatable and evidence-based, so that everyone can sleep well at night?

The secret is, there are no secrets. Good portfolio management is about focusing on what matters, using informed common sense.

• Second fine by UK regulator for high-charging “closet index funds”
• Fund manager and specific funds named for first time
• Manager failed to communicate change of strategy with retail investors and left fees high

What just happened?
The UK’s financial services watchdog, the Financial Conduct Authority (FCA) has fined Henderson Investment Funds Limited, the fund provider that is now part of Janus Henderson, £1.9m ($2.5m) for “failing to treat fairly more than 4,500 retail investors in two of its funds.”

The funds named are the Henderson Japan Enhanced Equity Fund and the Henderson North American Enhanced Equity Fund, which had been originally set up and marketed as actively managed funds.

In November 2011, the funds’ appointed manager Henderson Global Investors Limited decided to reduce the level of active management of these funds – effectively making them more similar to a passively-managed tracker fund.

Who was affected?
While this change of strategy was communicated to institutional investors, who were also offered fees to be reduced to zero, there was no such communication or fee adjustment for the 4,713 direct retail investors (who represented 5% of fund value by AUM), and 75 intermediary companies (for example, financial advisers) who remained invested in those funds. 

How long did this go on for?
This discrepancy continued between November 2011 and August 2016, Henderson allowed this discrepancy to continue with retail investors seeing no change in prospectus, objectives or fee levels while the fund was deliberately reposition to a more passive-style strategy: effectively Henderson wilfully converted two of its funds into closet index funds, but just didn’t tell its retail clients.

What was performance like during this period?
The charts below show the performance of each fund between November 2011 and August 2016.  The charts show the funds underperforming the index owing to active fees which creates heavier and heavier drag.

​Henderson Japan Enhanced Equity (old name)

In the fallout from the Woodford debacle, there are a several questions that the FCA should be asking over coming weeks.  Some technical, some compliance-related, and some propositional.
Here’s my checklist:
Start with the KIID.  The stated objective of the Woodford Equity Income Fund (“WEIF”) is “to provide a level of income together with capital growth.”  The stated policy is “to seek to invest at least 70% in shares of UK listed companies. It may also invest in unlisted companies, overseas entities and derivatives. It is not anticipated that the use of derivatives will have a significant adverse effect on the risk profile of the fund.”  So investors who read the KIID (which is meant to be all investors) understood that the fund would invest in unlisted companies.
Look at the factsheet: the stated objective on the factsheet of the WEIF is “To provide a reasonable level of income together with capital growth. This will be achieved by investing primarily in UK listed companies.”  Given most investors check factsheets, not KIIDs, why was there no reference to unlisted assets on the factsheet.  A small point, but, in my view, the objectives as stated on a factsheet and KIID should be identical verbatim.
Was there mis-selling? Arguably not.  The reference to unquoted assets is right there in the KIID, and implicitly in the word “primarily” on the factsheet.  And Woodford published all his holdings.  So caveat emptor.  But the trade-press and some brokerages focused much more on his large cap investment style than his unquoted investments, until they started turning sour that is.  So any mis-selling discussion would need to focus on the nature of the financial promotions issued by Woodford and to what extent they outlined the extent of the allocation, and associated risks, with illiquid assets and how the fund’s strategy was presented to potential investors.
Promotional materials: brokers offering the Woodford fund articulated his style (presumably based on Woodford’s own promotional materials) as investing in big solid companies with stable dividends.  There’s little or no reference to unquoted assets, so is it possible that investors (who rely more on buy lists and trade press) were unaware of the risks associated with illiquid assets.  So investors were possibly exposed to more risk than they were expecting.
Are there any similarities between the issues that arose for WEIF and the issues that arose with Invesco Perpetual?  The FCA published a damning 29 page verdict on the breach of limits by Invesco in relation to funds (including two flagship funds managed by Woodford), shortly before he left the firm.  You can read the full report here.  But to summarise, the issues in 2014 focused around “1) investing some of its funds in breach of investment limits; 2) introducing leverage into certain funds without providing investors with and 3) failing to put adequate controls in place to ensure that all funds were valued accurately and that all trades were allocated fairly between funds.  As a result of these failings, Invesco Perpetual’s investors were exposed to greater levels of risk than they had been led to expect.” Were similar issues arising at Woodford, and if so, who was responsible – any or all of the management firm, fund administrator, or the fund manager?
Limits for illiquid assets: to what extent did Woodford breach either in letter or spirit the rules around maximum holdings in illiquid assets for a daily dealing fund?  In early March, the holdings in illiquid assets hit 18%.  The two steps that will come under increased scrutiny were 1) the asset transfer of unquoted shares to WPT (where such investments are more appropriate) which, amazingly the manager, claimed after taking legal advice that “the shares-for-assets deal was not a related party transaction”, and 2) the attempt to list assets on TISE to get round the letter of the rules.
Compliance turnover: there has been a high turnover of compliance officers (those with the controlled function CF10 (Compliance Oversight)) at Woodford Investment Management and its predecessor firm Woodford Investment Management LLP.  Having three compliance officers in five years, according to the FCA register for those firm, raises its own set of questions.
Role of buy lists: in the non-advised sector, buy lists are helpful for investors who feel overwhelmed by choice and want help in selecting funds for each asset class.  Some brokerages offer their own buy list, like the HL50, others offer their own buy list alongside third party research from fund rating firms like Morningstar.  Buy lists provide an important resource, but will come under scrutiny.  Screening methodology, impartiality and oversight should be clearly defined and implemented.  Nor should buy lists be restricted to active funds.
Investor behaviour: ironically, behavioural research points to investors often being their own worst enemy.  Chasing star managers, or star asset classes (before a fall), not cutting losses early enough, over-relying on brands and personalities and not managing a broader asset allocation are all well documented failures.  Looking at behaviourally-adapted investment propositions, such as target-risk or target-date multi-asset funds, is one potential remedy.
Need for kitemarking: there is an overwhelming level of choice of funds for retail investors, both for single-asset strategies and multi-asset strategies.  Investing an entire portfolio into a single asset class – like UK Equity Income – is rarely likely to be appropriate.  And the biggest detriment to customer outcomes will be those investors who have all their wealth held within a single asset class and within a single fund.  There needs to be a discussion around the potential role for investment pathways (not crossing into advice) that use kitemarked multi-asset funds that are outcome-oriented and evaluated against stakeholder-style metrics including good customer outcomes and value for money.  In the US pensions market, safe harbour criteria give providers comfort that they are not giving advice when selecting a default strategy for less engaged, less confident investors.  Kitemarking would be a possible first step in this direction.
 
The views expressed are the author’s own and do not necessarily reflect the views of Elston Consulting Limited, its clients or suppliers.

​The broker and fund platform Hargreaves Lansdown has just brought out a list of recommended funds called the Wealth 50, which has received plenty of attention in the financial media.


HL used to have a larger list, the Wealth 150, but the list been gradually shrinking. The number of funds has been whittled down further and there are now 60 of them.


The company says that the funds have been selected after quantitative and qualitative analysis by its in-house research team. It has also negotiated lower charges for its clients. Wealth 50 clients will save, on average, 30% on ongoing charges, with the cheapest actively managed fund carrying an annual charge of 0.22%.


We lead such busy lives that when we’re offered a short cut, something that saves us time and effort, we generally like to take it, and that’s precisely why companies such as Hargreaves Lansdown produce these sorts of lists.


But are recommended fund lists, or buy lists as they’re sometimes known, really of any benefit to investors? Research by the Financial Conduct Authority, showed they can be very misleading. In its interim report on its study into competition in the asset management industry, the FCA reported that most funds on these lists fail to beat the market and that firms that publish them are often biased towards their “own brand” funds.


We shouldn’t be surprised. Academic research has consistently shown that, in the long term, only a tiny fraction of funds outperform the market on a cost- and risk-adjusted basis. Dr David Blake form Cass Business Buisness School puts the figure at around 1%. What’s more, he says, future outperformers are impossible to identify in advance.


The difficulty of identifying future star managers ex ante was highlighted in a paper published last summer, Investment Consultants’ Claims About Their Own Performance: What Lies Beneath?. It was authored by Tim Jenkinson and Howard Jones from the University of Oxford’s Saïd Business School, Jose Vicente Martinez of the University of Connecticut and Gordon Cookson from the FCA.


The researchers looked at the performance of funds recommended by investment consultants between 2006 and 2015. Once fees were factored in, they discovered, the funds that consultants didn’t recommend subsequently delivered better performance than those they did recommend.


We simply don’t know how long the 60 funds on the Wealth 50 will remain on the list for, let alone what sort of returns the funds will deliver in the future. No one can systematically pick winning funds in advance, and that includes Hargreaves Lansdown.


The bottom line is that recommended fund lists are not meant for your benefit at all. They’re essential a marketing gimmick which helps brokers and platforms to generate revenue.


HL is a very successful business, which has profited from a trend towards individual investors taking more control of their retirement savings. Since 2015 it has grown its active client base by 50% and its assets under management by 70%.


But its offering isn’t cheap. On top of annual fund charges and the on-going transaction costs that funds incur, HL clients also pay a platform charge of 0.45%. That may not sound like much, but the compounding effect of paying that charge year after year has a significant impact on long-term returns.


Don’t be tempted, then, to choose from this or any other recommended fund list. They really are best ignored.

• UK regulator forced a number of asset management firms to pay £34m compensation to customers for “closet indexing”
• Closet indexing means funds are presented as higher cost active, but actually just hug their benchmarks
• We estimate there is €0.4 to €1tr of assets in “closet index” funds in Europe, depending on what criteria are applied.  Either way, fund houses have been warned

“Mutton dressed as lamb” is a derogatory old saying of something or someone that’s dressed up to look better than it is.  In olden days, some dodgy butchers would dress mutton up to look like lamb to get a higher price.  I’ve got nothing against mutton.  It offers good value for money and does a nutritious job.  But I don’t want to be given one thing when sold another.
Some “active” funds that actually hug an index is another form of misrepresentation.  And this month, the UK regulator got tough forcing a number of fund houses to pay £34m compensation to customers overcharged in closet index funds.
As this is the first closet indexing fine of its kind internationally, it’s worth taking a closer look.

What happened?
The furore is around “closet indexing” where mutual funds charge active fees to deliver an investment style that pretty much tracks the index which it aims to outperform.  When marketed as active, this is misrepresentation.  Furthermore, closet index funds offer poor value for money compared to genuine index-tracking fund or ETFs for the same given exposure.

What exactly is closet indexing?
“Closet indexing” is a term first coined – in public at least – by academics Cremers & Petajisto in 2009.  The study and metrics around “active share” and “closet indexing” caused a stir in the financial pages on both sides of the Atlantic as active managers started to watch the relentless rise of ETFs and other index-tracking products.

In 2016, ESMA – the pan-European financial services regulatory coordinator – undertook a study whose findings were published in 2016, outlining the potential scale of the problem in Europe.
In a Market Study published by the UK regulator in June 2017, the FCA put asset managers on notice that it would be investigating closet index funds as an area that offers poor value for money for customers and potential misrepresentation.

In March, the UK regulator struck after sampling funds from 19 UK asset management firms.  Of the 84 suspected closet index funds reviewed, the FCA required changes to the descriptions of 60 funds to ensure they were not misleading.  Furthermore, an undisclosed number of unnamed firms managing an undisclosed number of funds were required to compensate their customers £34m: not for providing index-like returns, but for saying one thing and doing another.
To be clear, the issue around closet index funds is not simply about fees.  It’s as much about transparency and customer expectations.

How can you define “closet indexing”?
There has been some speculation as to what methodology the FCA used to deem funds a closet indexer.  In this respect, ESMA’s 2016 paper may be informative.  Their study applied a screen to focus on funds with 1) AUM over EUR50m, 2) an inception date prior to January 2005, 3) Fees of 0.65% or more, and 4) were not marketed as index funds. Having created this screen, ESMA ran three metrics to test for a fund’s proximity to an index: active share, tracking error and R-Squared.

The Closet Index Metrics in summary
Active share shows the percentage of the portfolio that does not coincide with index.
Tracking Error shows volatility of difference in return fund and index.
R-Squared represents the percentage of fund performance explained by index performance – a correlation measure.

On this basis, a fund with low active share, low tracking error and high R-Squared means it is very similar to index-tracking fund. But what are the thresholds for each metric and how many funds are caught in the net?

A trillion euro problem?
ESMA sets out three thresholds – each increasingly stringent – by which closet indexing could be defined.  These are set out in the table below:

ESMA Closet Index Evaluation Thresholds
Threshold/Tracking Error/% of European Active Funds/Est 2016 AUM Affected
Active Share <60%/TE <4%/15%/€1,200bn
Active Share <50%/TE <3%/7%/€560bn
Active Share <50%/TE <3% & R2 >95%/5%/€400bn
Source: ESMA, Elston

Based on Morningstar data we estimate the European funds industry to be approximately €8tr in 2016, implying on our estimates €1.2tr could be defined (at its loosest definition) as closet indexing, with €400bn (at its tightest definition) coming under particular scrutiny.

Where next for fund houses?
Fund houses in the UK and Europe have some thinking to do.  Are they offering building block components, or managing solutions?  Our view remains that those offering solutions will prosper, whilst those offering building blocks risk commoditisation.

Price pressure from index funds and ETFs has been present for a while, but so far traditional brands and distribution networks have proven resilient.  But with the regulator now joining in to target closet indexers, the “big switch” for core exposures from actively managed funds to index-tracking funds is likely to accelerate, in our view.

Embracing change
Rather than embracing change, European asset managers that don’t currently offer ETFs have so far been hesitant to launch.  They should get over it.  Fund houses have embraced different fund wrappers which have over time: investment trusts (one of the earliest just celebrated its 150th anniversary), unit trusts, OEICs, SICAVs, ICVCs to name a few.  ETFs are just a not-so-new tradable way of delivering a basket of securities to the investor.  Technology changes. Purpose does not.

So European asset managers should launch, not fear, ETFs.  Or watch their American cousins eat an ever cheaper lunch.

A winning formula
Tomorrow’s winners in the European asset management space, in our view, are those firms that are:
1) close to asset owners;
2) can offer solutions as well as components; and
3) are part of the low-cost revolution, not victims of it.
Fund houses that meet all three of these tests are in good shape.  There are some big British behemoths that don’t yet meet those tests.  Unless they act, they risk getting left behind.

Indexing and proud
Index investing is transforming the UK retail investment landscape.  It is creating a Moore’s Law for the fund manufacturing.  It’s time to get involved.



Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article has been written for a UK audience. Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange); “LON:” (London Stock Exchange). For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product. This blog reflects the views of the author and does not necessarily reflect the views of Elston Consulting, its clients or affiliates. For information and disclaimers, please see www.elstonconsulting.co.uk Photo credit: as per specified source; Chart credit: as per specified source; Table credit: as per specified source. All product names, logos, and brands are property of their respective owners. All company, product and service names used in this website are for identification purposes only. Use of these names, logos, and brands does not imply endorsement.

After equal measures of anticipation and fear, Vanguard has finally unveiled its D2C offer for the UK retail market.  Advisers should celebrate.  Sounds contradictory? Not at all.

What’s being offered
Firstly, a quick look at what is being offered.  Vanguard is offering direct access to its funds through with the option of holding them through an ISA or JISA, with a SIPP to follow.

Of most of interest (or rather for most ease), from a consumer perspective, will be the “do it for me” type of asset allocation funds that provide an entire portfolio management solution within a single fund. 

Specifically, the target risk funds, known as the Vanguard LifeStrategy funds, (with a fixed allocation to equity, e.g. 60% equity), and the target date funds, known as the Vanguard Target Retirement Funds (with a target date to match expected retirement date).

For these portfolio management funds, the OCF is, for example, 0.22% (the Vanguard LifeStrategy 60% Equity Fund).  Adding on some 0.15% administration fee for holdings below £250,000 and the all-in cost (“Total Cost of Ownership”) of 0.37% is highly compelling, when compared to existing DIY alternatives.

The right thing for the right segment
Vanguard going D2C poses no threat to advisers.  Here’s why:

1. The target market is existing and first-time DIY investors who historically don’t get a good deal elsewhere
2. Typical account sizes are likely to below the threshold that an adviser would consider taking on as a client
3. Larger account sizes who want to go Vanguard DIY are DIY investors already
4. Vanguard offers a convenient investment solution, through its asset allocation funds, not a financial planning solution
5. Financial planning is the adviser alpha that considers wealth structure, inheritance & estate planning, tax optimisation and can advise on pension transfers.  Neither Vanguard nor any roboadviser can offer those things – which are as important or even more important than access to market returns.
6. Relationships and trust are the one part of client service that cannot be commoditised.

So who should be worried?
Whilst having a multi-billion manager park its tanks on a well-mown English lawn definitely deserves a shiver of fear, that fear should not belong to advisers.

In my view, those that should be worried are:

1) Fund providers that can offer asset-class fund “components” but do not offer investment strategies delivered as funds.  The principle target of the FCA market study are the “closet indexers”, providing exposure to a particular market, but with questionable value for money.  Asset managers need to decide if they build components, run strategies or do both.  The most successful managers will do both, but to charge for the strategy, the components need to be low cost. Roll on ETFs.

2) DIY platform providers that can compete on value, but cannot differentiate themselves on service, brand or quality.  To a certain extent, platforms solve a problem – how can I access all the funds on the market, see all my holdings in one place, with ubiquitous online access? But it’s yesterday’s problem.  If the focus is on delivering managed asset allocation solutions, the DIY investor is struggling with how best to combine the thousands of funds on offer.  With asset allocation funds (target risk, or target date), the fund is the platform, and the fund has all the holdings in one place.

3) Roboadvisers that can offer a compelling interface, but offer generic investment strategies.  Both robo and Vanguard are offering ready made portfolios of ETFs.  The cost of delivering robo investment solutions via individual accounts will necessarily always exceed the cost of delivering investment solutions via a collectivised fund.  Besides, Vanguard has more firepower to spend on brand without need for impatient private equity backing.

Conclusion
Vanguard’s long-awaited UK launch is good for existing and first-time UK investors.  Its deflationary pressure is healthy for an industry that needs to think hard about what it offers.  Whilst some may be concerned, this is good news for advisers, and great news for the investors they can’t serve.

• BlackRock announced today that is cutting its fees on its iShares Core (US) range.  Investors can gain broad market exposures for 4-14bp.  This compares to 7-25bp for the iShares Core (UK) range.
• A diversified multi-asset 70/30 ETF portfolio will cost US investors can 8bp (that’s 8 cents per $100), compared to 14bp for a similar strategy for UK investors. Might the UK follow suit? We’ll see.

Big dreams
The cuddly  caption announcing the move says “Smaller Fees means Bigger Dreams”, which is warm-hearted.  But it’s also sort of fair.  Today’s retail investor has more access to breadth and depth of international markets than our parents ever dreamed of (if they ever dreamed of that sort of thing).

What does this mean, apart from being cheaper?
Well firstly, Moore’s law applies to ETF pricing & capacity as much as it does to semiconductors.  That’s not  new or surprising.  But the sustained deflationary pressure on fund fees is forcing the convergence of institutional and retail investment offers.  This will create pressures on asset managers that do not adapt.

Adapt to what?
The quest for elusive alpha from security selection looks like the right way of solving the wrong puzzle.
The puzzle to solve is how to design asset allocation strategies to help investors achieve their desired or required outcome.  Put differently, investment houses need to offer solutions (or “dreams”?), not products (“funds, OEICs, ETFs”).

Who are the winners?
Market access has basically become commoditised, so the only value in the value chain is in distribution (having customers), and solution design (giving them what they want).
Asset managers and financial adviser that embrace this new reality should flourish. Those that linger on in yesteryear’s product based world will gradually lose momentum.

NOTICES: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.  I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it.
This article has been written for a US and UK audience.  Tickers are shown for corresponding and/or similar ETFs prefixed by the relevant exchange code, e.g. “NYSEARCA:” (NYSE Arca Exchange) for US readers; “LON:” (London Stock Exchange) for UK readers.  For research purposes/market commentary only, does not constitute an investment recommendation or advice, and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.  For more information see www.elstonconsulting.co.uk Photo credit: coinquest.com Chart & Table credit: N/A