The return of the mutual fund

The re-creation of true mutual funds is without doubt an unintended consequence of RDR, but one advisers should embrace, writes David Norman, managing director and co-founder of TCF Investment

The original sound principles of mutual funds – the pooling of investor assets into low-cost, efficient and diversified vehicles that gained access to stocks and shares have steadily been eroded.

Costs have risen when they should have been falling. Fund proliferation is being driven by provider push rather than customer need. And substantial value has leaked from advisers and customers.

The RDR provides an opportunity to reverse these trends, create funds with guardians whose interest is aligned with their customers and lead to a significant boost in adviser capital – the return of the ‘mutual’ fund.

Vision

Advisory businesses, with high recurring revenues from a diverse source of loyal customers, will be highly valued. These businesses will have clear, simple processes that reduce internal risk and cost. They will recommend “low business risk” products that allow them to capture value repatriated from product providers as they treat their customers fairly.

While technology may not be the dominant force, it will allow costs to be reduced by creating process automation and improved service value for customers. It will also, in time, allow advisers to reach a wider set of consumers at low cost.

Standardisation of the product wrapper will drive costs down; the introduction of fee based models will see old “cartels” crumble; advisers will take on a new role in the investment value chain in part helped by greater professional standards; new adviser alliances will form.

Fund management is poor value – for customers and advisers alike

Costs of mutual funds have been rising when they should have been be falling. TERs have risen relentlessly over the last 10 years despite rapid advances in technology and assets under management doubling.

Manager incentives are more aligned to fund growth than fund performance. A customer investing in a fairly simple portfolio of mutual funds via a platform will face total performance drag of close to 4% pa vs. the market return.

This should scare us. If the long-term equity risk premium is around 4%pa it means that, in aggregate, the efforts of all of us can only lead to the customer being worse off than they would have been in cash.

Consumers have been duped into expensive products promoted with large advertising campaigns. Managers hid behind a supposed information advantage and have sucked massive capital value from advisers.

The number of pooling vehicles (funds) in Europe now rivals the number of large cap stocks. It seems to me this situation is not one driven by customer demand – it can only really be because it is easy to launch a fund and make money from customers. And in aggregate it means the industry is self not customer serving.

Time for change?

RDR allows a new market dynamic where advisers use the combined assets of their customers to drive better products and more value for themselves. Fund managers may be in for a surprise.

And not just fund managers – it can be no  surprise the FSA is concerned about the rise of platforms because it fears they merely represent a new form of product provider where the customer suffers from the opaque and powerful forces that capture large numbers of advisers and thus distorts market efficiency.

Capital value

As recent asset management transactions have demonstrated there is huge equity value in a large, well diversified pool of retail assets.

Two value drivers stand out:

• Higher margin – as funds grow in size the profit margin grows too. Costs associated with running funds are almost fixed – you only need one manager to run a fund no matter how big it gets. And technology should be massively scalable.
• Diversity (and stickiness) of revenue – a manager with lots of retail customers is more valuable that one with just a few institutional investors – they are unlikely to leave in one go.

A quick calculation suggests the total value of the UK retail mutual fund industry is around £13bn. In addition there are:

• £450bn of retail assets.
• Average fund manager’s profit margin is 25bps (0.25%pa).
• Market multiple for asset managers at 12 times profit.

It seems somewhat perverse the bulk of this value has been created by the efforts and energy of advisers, and yet it all belongs to the product providers – that is hardly an efficient market!
DIFs are not the answer.

A number of advisers have identified this pool of capital. Some have tried to recapture it by setting up so-called distributor influenced funds (DIFs). The FSA is concerned about DIFs and is right to scrutinise them robustly.

The key point here is that value accrues to the entity that owns the contract to appoint the fund manager – rather than the actual fund manager.

If an adviser buys an OEIC/unit trust from a provider that appoints the fund manager (usually themselves) then the provider owns the value in the contract. If however the adviser appoints the manager inside an OEIC then the value belongs to the adviser.

It is quite possible to set up an OEIC wrapper with a truly independent investment adviser (without additional revenue flowing to advisers – one of the criticisms of DIFs).

Consider the difference between an adviser recommending a SIPP with a range of assets (active or passive) within the wrapper or recommending an OEIC wrapper where the adviser awards a contract to a manager (or series of managers) to run the assets?

Are adviser mutual funds any better?

What about a group of advisers coming together to pool assets into an OEIC wrapper with an outsourced and independent investment committee that awards the mandates?
This is now a relatively simple and low-cost process:

• The UCITs revolution has driven down the costs and boosted the availability of administering OEIC wrappers.
• Advisers pooling assets can drive down costs for their consumers – using their buying power.
• A simple range of risk graded funds means the needs of most customers can be easily met.
• Truly independent asset allocation or portfolio overlays are available at low cost – or can be provided by increasingly well qualified advisers.
• Passive funds/ETFs mean that multi-asset funds can be created with much lower TERs than most current mutual funds (and much lower than a FoF arrangement).
• The diversity of revenue stream from a group of advisers collaborating is much greater than a single adviser.
• Costs to the customer is reduced due to scale.
• Advisers create a new capital pool (in essence funded by taking the management contract away from existing managers).

Each £100m of assets with a 25bps margin could have a market value of around £2m based on a multiple of eight times.

RDR is having a huge impact on advisers – but the impact on providers is only just being understood – it has the potential to be game changing.

Massive existing inefficiencies in fund managers are being exposed by advisers who are experiencing the transparency demanded by RDR.

The growing professional qualifications of advisers are removing the information advantage that fund managers once had. There is a great opportunity for adviser to recapture a good slice of the £13bn of capital they were the engineers of in the first place – while overseeing the development of low-cost, efficient pooling vehicles.

Perhaps in future asset managers will provide equity participation to advisers as well as their star managers.

The re-creation of true mutual funds is without doubt an unintended consequence of RDR – but one to be embraced by advisers!