The performance game, weak price competition and the FCA
The FCA wants to intervene to strengthen weak price competition in asset management. But it’s inherent in competition driven by investors playing a performance game. What intervention can change that? Not much, we say. But change is on the way even without the FCA.
The UK regulator published yesterday its final report on the UK asset management industry, confirming one of its key findings in its interim report: ‘We find weak price competition in a number of areas of the asset management industry. Firms do not typically compete on price, particularly for retail active asset management services.’ Weak price competition is a good reason, given the FCA’s mandate, for regulatory intervention.
Effective intervention needed an insight the FCA has not clearly demonstrated it benefits from. This is that the more effective price competition it seeks is inherently incompatible with competition driven primarily by performance. I recall this being well understood in the FSA some two decades ago when it had a stronger academic support staff and produced papers that challenged the industry on its intellectual premises rather than just on business practice and rule following.
Though it is an explanation of behaviour it is a fundamentally rational model. It can explain why there is no link between ex post performance and investment costs, because in a performance competition it is ex ante probabilities, not known, that count. It can explain why large funds do not cut costs to prevent loss of assets or to gain more assets and instead adopt inertia tactics. It explains the process of the creation of new funds and the closure or merger of old funds. Combined, these factors in turn explain price clustering and price stability at high levels.
In this analysis, it is only when customers act on this insight that overall costs fall. Even then, it is not necessarily by competition but rather by movement between two mutually exclusive sets of solutions. Within the performance-driven segment, price behaviour may look unchanged but the base is smaller. The FCA appears surprised that the challenge of index tracking has not had more price impact on active management charges. It is missing this point.
The two most influential market-based changes that have eroded the base by moving assets out of the performance competition are index tracking and liability-driven (or outcomes-based) investing. What they have in common is a more agnostic approach that is intellectually opposed to the confidence implied by active, judgement-based performance competition. The good news is that both are continuing to erode the total amount of money playing the performance game even without regulatory intervention.
Passive being an opt-out it excludes the possibility of cost/benefit trade offs. Such trade offs should, however, show up in a link between ex ante performance probabilities and costs in terms of the size of the bets taken by active, confident managers via such measures as ‘active share’. Even if the measures are not perfect, the concept is gaining traction and challenging irrational cost/performance premises.
The concept of a potentially irrational value proposition does offer some scope for regulatory intervention. It is a long time since ‘value for money’ featured in the handbook, perhaps because it was too woolly a concept. It requires this to be explicitly addressed as relevant for anyone (provider, manager, adviser, consultant) owing a duty of care to act in their clients’ best interests. The FCA final report does float this idea but it needs to be much more explicit.
The important role of agents in this regard is recognised and the report has not backed off requiring institutional investment consultants to be regulated by the FCA and brought under its tests of duties of care.
The way these important shapers of intellectual premise behave has always been likely to affect the development of alternative propositions to conventional performance-driven allocation. It is striking therefore that they were not universally in the vanguard of the movement to liability driven investment (much of the sales effort came from a few investment managers against encumbent consultants) and have not generally been more powerful advocates of passive investing. This reflects a commercial judgement of where their own interests lay. It is entirely consistent with this cynical view that their main contribution to change in recent years has been the growth of fiduciary management (consultants managing the money instead of advising on how to manage the money). This has served not to challenge but to replicate and embed the performance proposition as the basis of competition.
In a leader in today’s FT, below the heading The FCA slogs on in a war worth fighting, the writer suggests none of the FCA’s specific proposals will change ‘the fundamental anti-competitive feature of the market: the fact that managers sell hope’. It goes on: ‘This does not make the report futile. It means instead that the results will be incremental, gains will be hard fought, and the work will never be done.’ I think that can be more accurately expressed. The base that is not exposed to price completion will continue to shrink without intervention but intervention can deal with the high cost of part of the base by bringing the rationality of the value proposition, via tests such as active share, into the scope of a duty of care. Either it stays in the base but costs are reduced or it moves out of the base and into passive. But it is true 'the work will never be done' to the extent some base of game players will remain.