Eight years after the global financial crisis, the spotlight has well and truly swung from banks to asset managers. Banks now have to meet capital requirements, face stress tests every year and, in Europe at least, they’re not allowed to pay employees more than 100% of their salary as bonus (200% with shareholder approval).
The UK FCA’s review of competition in asset management made for uncomfortable reading. It is tempting to interpret it as a clear statement that you’d be mad to ever invest in active funds; that you would be much better off in passive funds.
But that would be a false assumption.
Passive funds certainly have their place. But active investment management should and must have a major role in the investment industry of the future. Indeed, it is vital that active investment management as a whole reforms itself. If it does, it will deliver both the long-term returns that ultimate beneficiaries need and, through the long-term allocation and stewardship of capital, deliver those returns in ways that have a strongly positive impact on the economy and society.
The FCA is not challenging the validity of active investment management, but its review is certainly a major challenge to the status quo. One problem for active management is that the sum of the active management industry cannot outperform the market over time. There’s nothing that can be done about that.
But another major problem is that a very significant proportion of the active management industry is part of a capital market chain that is short-changing both the ultimate providers of capital and the economy. And something can be done about that.
The problems are hard-baked into the current system because of perverse incentives and excessive intermediation, which leads to short-termism and a replacement of long-term investment by trading and speculation. It’s been a very safe place for the industry to be. Even since the crisis, the industry’s AuM has doubled. Revenues, profits and pay have all risen so there has been precious little impetus for significant change.
The end of benchmark-hugging
But now the pressure is rising. The FCA’s review, media comment and the work of the Transparency Taskforce among other factors is creating a window of opportunity for change. Active investment managers who respond appropriately can better serve beneficiaries, society and their own shareholders.
The FCA’s proposed prescriptions of stronger governance and sunlight will hasten the end of active management that cleaves closely to a benchmark. Frankly, if what you want is to beat an index by a bit every year – forget it. You’ll almost certainly be better off in the long run by just finding the cheapest way of replicating it.
When investors, advisers and active managers are solely focussed on not underperforming the index by too much, perverse effects ensue.
A manager that underweights a stock is rewarded with relative outperformance if that stock underperforms the market. But I am at a loss to understand why I should paid an active asset manager to buy shares in companies that it thinks are going to do badly.
A managers that underweights a stock also has no incentive to engage with the company board to try to initiate improvements – as success negatively impacts the manager’s relative performance. This leaves companies with significant proportions of their shareholder base disengaged.
The FCA’s proposed rule that asset managers should always act in the best interest of their client will be hard to meet under that model.
The future for active lies in high conviction, low turnover, long-term, high-engagement styles where managers offer a distinctive differentiation from passive or smart beta strategies. This will also lead to more active stewardship for better long-term outcomes not only for beneficiaries, but also for employees, innovation, tax transparency and corporate integrity.
Many good managers recognise the systemic pressures that inhibit long-term thinking and diminish returns to investors and society. But the capital market system is highly resistant to radical change.
That’s why The People’s Trust, which has crowdsourced its set-up costs from over 2,000 founders, is being established as a mutual enterprise. With no external commercial shareholders and no bonus schemes for employees, it should be able to avoid conflicts of interests and put its shareholders’ long-term interests first every time.
Daniel Godfrey is a co-founder of The People’s Trust and a former head of the Investment Association