Simon Ellis, principal of Strategies in Asset Management, analyses the impact of tumbling fund charges and the unanticipated shocks RDR has had on the fund management industry over the past year.
Following Bonfire Night earlier this month, it seems strangely appropriate to reflect on the impact of the Retail Distribution Review (RDR) on the retail funds industry. The question to ask is, is RDR the fund industry’s version of the Big Bang?
For starters, it is clear power in the value chain has now shifted irrevocably from providers, to distributors and advisor firms. In addition, the battle line for margins within the value chain have now been drawn up. The short-term situation is noisy and confused. But the forces in play now, will cause greater long-term change than many have anticipated.
The pre-RDR value chain was largely controlled by providers. The reason is simple – bundled charging. Providers controlled the level of charging to the customer, and the distribution of the resulting revenues across the value chain.
The fund industry’s Big Bang?
While there was room for some negotiation, the capping of total revenues through annual management fees at a typical 1.50% meant each participant had to take a share of that fee. The market norm became 75bps to the manager, 25bps to any platform and 50bps to the advisor – regardless of the relative value each party might be adding to the customer.
In this old model, distribution was highly fractured, with plenty of small advice firms wielding little bargaining power. There was a limited number of large distributors or centralised fund buyers, meaning all fund companies could hope for support from someone. Passive funds were used occasionally.
Fund management fees were not seen as a competitive factor, and so were set at a standard level. Additional expenses in the total expense ratio were rarely considered important. Even where fund of funds’ combined total costs exceeded 200bps, price sensitivity was low. Relative fund performance and star fund managers were the currency of competitive behaviours.
This all seemed to work. Yet the strains had already been showing, as some advisors moved to fee-based eschewing the 50bps trail approach. Critically, platforms had dis-intermediated fund managers from distributors and clients, and challenged the control over revenue streams wrapped up in the annual management charged-based model.
A slowly growing number of distributors were exercising leverage to secure special private rebate terms, as fund managers were losing their grip over the value chain.
The credit crunch and poor investment returns in that period were also undermining confidence in active fund management. The unhappy coincidence with RDR, and full transparency, ensured the old model would be broken forever without effective challenge from fund managers.
New value chain
The new value chain bears resemblance to an engine, in which the advisor and distribution company wrap themselves around the client, and choose products and services which help to manage clients’ affairs more effectively.
Fund managers are now isolated from the customer, and distributors determine not only what funds and services the client will have, but also how they will access them and how much they will pay. In this model, (shown in the graphic below) advisers question, ‘Who adds what value to my customer, and what is that piece of value worth?’ Platforms have become the central interface between the demand side and the supply side, with other service providers, outside the core, seeking to add value to the distributor business itself .
While advisers adapt to their new position, the other parties are seeking to stake their claim for a share of the fee cake. Without a cap on fees in the form of an AMC, each party is pressing for what they think they are worth.
FCA will claim the apparent halving of fund management fees to the customer, from 1.50 % to 0.75%, in the open market is a major and immediate win from RDR. Indeed, speaking at the FCA’s asset management conference last month, Ed Harley, head of asset management, said RDR had sparked “some really healthy competition”.
However, if you add average levels of additional expenses, platform fees, portfolio management and adviser fees to the typical investment charge of 75bps, the total cost of ownership is closer to 230bps.
Are these total costs sustainable? The market’s immediate answer has been ‘no’. It is focusing on the costs of investment, either by switching more to passive funds, or by attempting to squeeze fund managers on fees.
The move to ‘clean fees’ is a simple transition to unbundling, stripping out platform and trail fees and leaving the net figure available to all intermediaries. However, for previously ‘preferred distributors’ this is, in fact, an increase in their net fees, and they are not happy.
Understandably they wonder why the terms they had before, recognising superior volumes and overall efficiency, cannot be replicated through the creation of new ‘super-clean’ share classes. This is where transparency is ‘the killer app’. If everyone can see a manager can sell a fund for less to some people, why not all? Or, as some are saying, ‘Why not at least me?’
As the share class debate rages, other service providers cannot afford to be too sanguine. Platform models have fees ranging from 10bps-45bps, but how many of the bundled services do clients or advisers truly want? Why are there so few transaction-based fee models, where costs might be closer to 10bps? And those additional expenses?
Looking across the industry, these range generally from 4bps-20bps, but why the variety between providers? And don’t some of those services behind the scenes duplicate those provided by platforms? A distributor will be wondering what is the value of all these mouths to feed relative to the value of financial planning?
A confusing 2014
Dare one predict the future? In the shorter term, it is unlikely the fee debate will last much beyond the new year. Looking further out, it is unlikely the overall market will settle until the impact of the confusing regulatory timetables for rebates in 2014 and 2016 play themselves out. However, it is not unreasonable to expect total costs to fall to a range closer to 180bps-200bps, with all parties except advisers taking a hit.
We should not be surprised to see multiple share classes stretching to include individual distributor specific ones at surprisingly low levels . ‘Super-clean’ looks set to move to 65bps for active funds, with the very real threat this becomes the new norm for ‘clean shares’ too.
Differentiation may then have to move to being more service than price-based. Do not be surprised to see more moves to segregated mandates where underlying fees are less obvious for the same capability.
The squeezed middle
On top of this, additional expenses will likely fall into a tighter range (3bps-8bps?) with the possibility a single unitary fee, ie, a composite of investment and administration, is seen as clearer and fairer for all.
We should also expect to see a fund industry version of ‘the squeezed middle’, with platform fees falling as distributors unbundle platform services, and as clients question ad valorem fees over cost per transaction and a base fee. We could see a fight between platforms and third-party administrators to provide additional services to the fund managers themselves.
Just as in 1986, structural reform caused unanticipated shocks to the banking and broking world, RDR and 2013 may come to be seen as the fund industry’s seminal moment – our very own Big Bang.
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