I started thinking about this article by listing the positive and the negative factors for UK asset managers. The list of the negatives is a lot longer than the list of the positives. Unfortunately at present legal and regulatory issues have undue prominence over far more important issues of investment performance, new product development, and innovation in service delivery and distribution.
The potentially negative impact of Brexit on financial services including asset management has been much in the news, as have critical comments in the UK FCA Asset Management Market Study's Final Report. At the same time managers face a deluge of European driven regulatory change, especially with MiFID II coming in from January 2018. You might therefore think that it is all doom and gloom. But this need not necessarily be the case.
I prefer to believe in a more positive narrative: With a team effort of the asset managers, the FCA and Government, we could have a golden – perhaps one off- opportunity for a major imaginative re-think of how UK asset managers operate and what UK investment fund products we can offer.
First, do not underestimate the positives:
- Respectability: The UK is recognised as a reputable and well-regulated jurisdiction in which to do business – and one in which people would wish to do business even post Brexit.
- Regulatory engagement: Open engagement between the regulated and the regulator differentiates the UK from some other countries where the regulator takes a more enforcement driven approach. The FCA is winning plaudits for its Project Innovate with its Sandbox and Advice Units helping both established and new entrants work with regulation when innovating.
- Government initiatives There is a positive willingness to work with the industry in areas of innovation. HM Treasury recently observed: "The Government's vision is for UK financial services to be the most competitive and innovative in the World, supplementing existing services with greater choice and value for consumers."1
It is acknowledged that asset management has an important role to play, both in providing savings products and in financing business – Take HM Treasury's Patient Capital Paper published this month which acknowledges how pooled investment vehicles can provide important funding to businesses looking to scale up.
Even so there are major issues to be addressed.
Numerous issues are identified in the FCA's Final Report on the Asset Management Market Study. We already have formal proposals for improving governance by requiring independent input and autonomy for fund managers. A further package of measures is to be in place, or proposed by, the end of Q1 2018, including better expressing fund objectives, addressing benchmark and performance reporting issues, and better disclosure of fees.
It is important though not to focus solely on this one Study on regulatory issues, which was devised principally to focus on the value for money and poor competition motivations.
A better starting point is to consider the vast range of developing investment market and investor dynamics, and technological solutions disrupting many parts of the business, and to take a holistic view on the commercial landscape before coming back to appropriate law and regulation. For example:
- Distribution: Every aspect of the distribution landscape is changing.
With the growth of investment platforms, individual investors are increasingly making their own investment decisions without advice. Institutional investors are operating via their investment consultants. Accordingly asset managers are further away from their target investor base.
The launch by the FCA of its Investment Platforms Market Survey should be welcomed – it will be a difficult area to regulate but, with the growth of AI technology and the need under MiFID II for there to be an increased focus on product governance both by product providers and product distributors, it is a vital area to get right.
- Advice: Arguably we have increasingly complicated products – and different sectors providing comparable products; and greater expectation that an individual will take responsibility for his or her own investment needs. The need for advice has probably increased whilst the provision of it has decreased.
The FCA's Retail Distribution Review initiative has succeeded in many ways of ensuring that advisers are better qualified and reducing bias because of incentives. But an unintended consequence has been an increasing reluctance for investors either to take advice and/or to pay for that advice, and the number of advisers has fallen.
The change of the boundary of the regulated activity of investment advice with effect from January 2018 will help UK authorised firms provide a variety of guidance services which fall short of personal recommendations, but is this enough?
- Comprehensibility: Retail savers, and indeed with some institutional investors, often fail to understand the products in which they invest. This does not matter so much where there is a professional adviser advising, or manager making the investment selection, but it does matter increasingly where investors make their own decisions.
The first thing to fix should be access to sufficient and clearly expressed information so investors can take an informed decision. Some of the standardised formats required by regulation (for UCITS KIDs and prospectively PRIIPs KIIDs) are not ideal. Various initiatives on smarter consumer communications should assist but there is a wider need for general education on financial products that should be addressed too.
- Savings incentives: Investors should be encouraged to save, and to save regularly. There has been a woeful decrease in the savings ratio for individuals. To some extent, the tax incentives are arguably failing to hit the right mark, except perhaps for ISAs.
EIS and SEIS, Business Property Relief (BPR) and incentives for AIM stocks might be encouraging retail investors into some of the more risky strategies – and indeed over focus on such.
Ideally, in conjunction with investor protection initiatives from the FCA, HMRC would be asked to look again at how effective tax reliefs can best be targeted, whilst appreciating the need to limit the cost to the Exchequer of tax breaks.
- Arbitrage: Different business models with differing levels of regulation can offer the same or similar commercial outcome. It is now recognised that some of the newer business models can circumvent regulation. The FCA is likely to take action to reduce any arbitrage opportunities: for example in crowdfunding where some now operate in a way which really ought to be within asset management (or banking). Asset management propositions should be presented (and regulated) as asset management.
- Investor protection: A key challenge remains how best to provide investor protection. This should not however necessarily mean prescriptively restricting interactions with retail investors and limiting the types of products in which they can invest.
It is surely better to allow a full choice of product with the risk of the odd one being unsuitable, than to limit unduly the range of investment solutions offered. Investors should, to a greater extent, be trusted to take their own view, and assume the consequent risks, if they wish to do so.
- Culture: Of course, in all aspects of product manufacturing and the product distribution, it is vital that all involved take a principled approach which seeks to have best regard to the interests of investors.
The FCA is to roll out the Senior Managers and Certification Regime ("SM&CR") to most types of financial business, including asset managers. The new SM&CR regime may formalise the regulator's expectations and may introduce some way of disciplining individuals who fail to demonstrate them. But why are these ethical principles not followed in the first instance? Culture comes from those at the top and it is vital that boards of assets managers and fund management companies are strengthened and better demonstrate sound governance and that they act in investors' best interests.
So, if these are the problems, what is the solution?
First, I would first emphasise the need to rebuild trust and confidence in UK asset managers and their product ranges, with some degree of sense and proportionality for both the regulation of these and criticism of them. It is easy to destroy trust and confidence but very difficult to build it back up again. Constant public criticism of the industry is itself to everyone's detriment.
With Brexit, we will have to do something, so I would suggest that we take the opportunity to be ambitious in modernising the legal and regulatory framework for UK asset managers. Here are some suggestions:
- Suggestion 1: Ensure that delegation from EU firms is fully workable
There is a firm trend now to look at UK funds for the UK investors and to use funds domiciled elsewhere for investor elsewhere – notably Luxembourg and Dublin. There seems little we can do to stop this general trend and so the focus is on retaining portfolio management in the UK.
We can expect a strengthening of substance requirements of EU based asset managers – each of UCITS ManCos, AIFMs and MiFID investment firms – within the EU home member state. It is vital though that there can be effective reliance on delegation arrangements back to the UK portfolio managers.
This would be despite ESMA's set of July opinions which included various comments that are unhelpful to this approach. ESMA is effectively expecting that relocating entries must have transferred a sufficient and substantial amount of portfolio management and/or risk management functions to their new home Member State.
The opinions are non-binding indications to local regulators, and the legal basis for some of these assertions is debatable, especially for UCITS funds, so the battle is not yet lost but this is one that the UK should be fighting.
A priority for Brexit negotiations is to ensure that delegation arrangements can still work effectively post Brexit. This is not only in the UK's interests. Luxembourg and Ireland will have their own concerns if the ESMA opinions are followed as currently framed. Existing third countries with delegated mandates from EU firms should also be worried about their implications.
- Suggestion 2: Allow access to a wider product range
UK investors have for too long been precluded from accessing a full choice of product. Restricting choice has always caused some friction and will increasingly mean that investors cannot access relevant investment solutions for their portfolios.
Without the need for expensive discretionary investment management arrangements or advice, investors should, under certain circumstances, be able to access a wider range of products than the rules currently permit. It need not be contrary to investor protection concerns, and there may a strong and developing logic for this proposal.
More generally, we should rethink the traditional divide between institutional and retail investors. The people behind the institutional investors, notably the pension schemes, have in fact always been the retail individuals. If we have a switch of long term savings responsibility from the institutional side to retail investors' personal savings – or, with DC occupational pensions, the investment returns risk being borne by the individual scheme members, it is even more important that individuals can have access to all relevant asset classes, including alternative asset classes and generally products with a longer timeframe.
- Suggestion 3: Extend the range of UK investment funds to fit modern demands
We should improve the range of types of UK investment funds and categorisation of funds which the UK can offer. We could devise radical proposals for using UK asset management and UK investment fund products and services, both to the UK investor base and potentially to investors globally (perhaps ex EU 27, should single market access preclude effective access to the EU).
- First, for UK authorised investment funds
We need to reinvent the UK fund labels because UK UCITS will cease to be UCITS post Brexit, and we will (hopefully) remove the rather odd non-UCITS retail fund or “NURS” label
One could just rename UK UCITS and NURS funds as “UK retail funds” and sort out a replacement provision for importing non-UK funds, on the basis that we are bound to keep selling in Luxembourg and Dublin based UCITS, and possibly a wider range of funds too, in our usual fair minded fashion.
This is however our golden opportunity to reinvent a better range of well-regulated and respected FCA authorised funds, suitable for both retail and institutional investors. It would be good to think from first principles and devise a broad ranging UK authorised investment fund product range.
- The opportunity could be taken to have a single diversified category of UK funds available to all types of investors with a principled rather than a detailed prescriptive approach on investment powers for retail funds. (UCITS III investment powers have not proved popular in certain markets.)
- We could also permit a wider range of authorised investment funds with more limited target investor types.
- or all fund types, we could revisit whether they should invariably be open ended. There have been a few initiatives for limited redemption and limited issue funds – and there is some latitude for QIS schemes to have arrangements to match their investment strategy. But nonetheless they remain essentially open ended funds.
With long term saving horizons, there is considerable logic to encouraging investors to invest in funds with longer term time horizons. Whilst one can sympathise with the old-fashioned adage that most investors should be wary of illiquid assets, this is not in the immutable rule. It would be more helpful to encourage investment in a diversified pool of illiquid assets than further encourage individuals to focus, as many have done recently, on large exposure to direct holdings in real property which fail on diversification and liquidity attributes.
HM Treasury in its August 2017 paper on Patient Capital: Financing Growth in Innovative Firms – has looked at the challenges of businesses accessing funding. Owing to issues in accessing funds product and the lack of closed ended UK authorised investment funds, its focus seems to be on the listed companies, and investments trusts in particular. The resurgence of investment trusts is not a bad thing but it does mean that investors are exposed to general market risk, as investment trusts can trade at a premium or discount to NAV. Having some form of closed ended, or at least time horizoned, authorised investment funds with relevant buy back arrangements after certain timeframes would perhaps be a more imaginative answer to the problem and give investors a true NAV related return.
- Secondly, add to the structures available as UK domiciled unauthorised investment funds
At the moment we can only modify standard Companies Act corporates to be closed ended corporate funds which are AIFs, and (for limited purposes) work with limited partnerships and (if suitable from the tax perspective) use unauthorised unit trusts.
We could fill the gaps in our armoury: Investment companies with variable capital can only be set up as authorised funds, and we need the unauthorised version. The notion of “puncs” was suggested when UK OEICs were devised but was never followed through. We might also benefit from tax effective unauthorised unit trusts for wider purposes – and unauthorised contractual schemes too.
If we do not, we will be even further behind Ireland with their ICAVs and Luxembourg with their RAIFs.
There is huge scope for a good news story to emerge. These three suggestions could potentially transform the prospects for the UK’s asset management industry but to carry them through would require considerable positive thinking, and a real team effort from asset managers, Government and regulators.
1. HM Treasury's Regulatory Innovation Plan April 2017