Among the many interesting items in the Financial Conduct Authority’s bracingly good if rather understatedly named Asset Management Market Study Interim Report, aka MS 15/2.2, was a small bit on “risk-free box profits”.
Would you like some risk-free profits? I would
This little gem makes its first appearance on p. 129, as the second bullet point under paragraph 7.23. Quite justly, 7.23 is focused on identifying costs that are “not included in headline rates (such as the OCF [Ongoing Charge Figure]) and so are not as transparent to investors.” The biggest of these hidden costs, understandably occupying the bullet-point of first rank in 7.23, is transaction costs.
At Morningstar we firmly believe that transaction costs should be baked into the cost figure given to investors. Transaction costs can be thought of in two strands: Explicit costs that are fees paid by funds to brokers to buy and sell securities plus associated stamp duty; and implicit costs that arise from security prices moving against the fund as it trades, and any cost in forgoing trades that cannot be executed at an acceptable price because of such price movements. Both are measurable costs that fund investors bear on an ongoing basis and should be clearly disclosed as part of any cost ratio. Furthermore, doing so might just have the salutary effect of giving fund managers incentive to trade as efficiently as possible.
Risk Free Box Profits
Now: “risk-free box profits”. Think about that phrase for just a moment. Would you like some risk-free profits? I would. Alas, such things are fleetingly rare because in a well-functioning market they would be quickly arbitraged away. The reason they exist in this case is because the relationship between fund houses and fund investors is not a well-functioning market: one side, fund houses, holds a decisive information advantage over the other, investors, and in this case has used this advantage to quietly keep for itself money that was intended for another purpose. It is as simple as that.
The issue arises from the dual pricing mechanism used by most unit trusts, whereby the trust will quote the price at which it will issue units and the price at which it will cancel them. The difference between the two is meant to capture any sales charge – less of an issue post-RDR – plus the cost of executing any trades needed to create or cancel units. However, asset managers are often able to net out buy and sell requests against each other so that no trading is required to fill these orders, meaning that no costs are incurred. And yet in these cases, they still collect the “spread” and pocket it as profit.
This is plainly ludicrous. Managers who use a dilution levy to compensate investors for the liquidity impact of trading in fund units are specifically banned from keeping the money as profit; per the FCA Handbook COLL 6.3.8.3, all such levies become the property of the fund. Because the spread on a dual priced fund is not technically a dilution levy, it is not subject to these rules and so the unit trust managers are permitted to keep the money.
The situation reinforces the need to ban dual pricing – it is opaque, it puts investors at an informational disadvantage by making pricing harder to understand, and it has resulted in their money being pocketed, risk-free, by fund houses.
If an outright ban on dual pricing is not forthcoming, then the FCA should simply treat all spread proceeds in excess of the initial charge as a dilution levy, requiring that the proceeds become the sole property of the trust to the benefit of its investors.
