Both asset managers and advisers in the UK and Europe are facing a spate of new regulations that dramatically affect their businesses. Setting money markets aside, two of the more notable are RDR and the proposal for a cap on pension fees. At the European level, we’ve also seen proposed regulation of fund manager bonuses.
In these cases, the regulator is effectively saying that the market is not functioning properly. In the UK, in the case of RDR, it became clear that the lack of any link between adviser compensation and the level of service they provided for investors, and the skewed incentive that resulted from being paid commission determined by the fund company, were unsustainable. In the case of pension fees, the focus is on the apparent lack of meaningful price competition and the opacity of fee disclosure.
Both regulations present a classic principal-agent problem. Regulation is not always the answer, but if the industry fails to adequately police itself, then it may become the only viable answer.
Asset managers face a clear conflict of interest every day—how they address this conflict matters greatly, and if they had addressed it differently, the regulatory outcome just might look different from that which we’ve seen.
The conflict is simple: Asset managers need to serve two masters: the stakeholders in the management company, be they partners, private owners, shareholders of publicly traded entity, and investors in the funds they run. The two are often conflated by asset managers who argue that their firms only do well if they serve investors well. This is of course utter nonsense and shouldn’t be given the least scrap of credibility. While truly poor performance for investors is highly unlikely to be the basis of a successful business, mediocrity, high fees and great distribution have proven solid business models for many asset managers over the years—to investors’ detriment.
Two key areas where interests are in conflict are in fee-setting and capacity management. Bigger funds and higher fees equal greater profits, but can be quite harmful to performance delivered to investors. If the regulators wanted to be helpful, by the way, they might introduce a clear mechanism for funds to close themselves to new assets. As it is, funds have to either put up charges to an unattractive level or widen out spreads in the case of dual priced offerings, which seems suboptimal to say the least.
There is also an element of short-termism that can become increasingly manifest when firms are under pressure to deliver more to their own stakeholders. This can inspire hot-dot fund launches, for example, in areas where the manager might not have real skill, or fee rises, alterations to investment mandates, or rapid-fire manager changes.
The key for asset managers, we at Morningstar argue, is to focus on the long game. Instead of thinking about how they can grow revenue and profits over the next quarter, year, or five years, managers should be asking themselves how to build and retain investor trust for decades. This requires a markedly different mind-set. One might, for example, strive to keep fees low in order to maintain strong performance, or limit flows to capacity-constrained funds or even just funds where flows are hotter than they should be. It requires thinking not just about the amount of inflows a new fund launch might garner, but about what the clients who invest into that fund might think of the firm 10, 15 or 20 years hence.
There are many levers firms can pull to have success for a time, but to build a durable business, focusing first and foremost on creating good outcomes for fund investors and letting revenue and profits follow is the logical choice. If enough followed this path, it also just might limit the need for regulators to intervene with potentially costly new rules.
This article previously appeared in FT Adviser magazine
