The UK's Retail Distribution Review has caused turmoil for independent financial advisors (IFAs) and fund managers that is reminiscent of the 'Big Bang' of 1986 in the banking world, but much was already changing before it began. Simon Ellis, the principal of Strategies in Asset Management Ltd., presents Part One of a sweeping panorama of the asset management and advice industry in both its old and new forms.

Once upon a time, the World was flat.
There was a natural order of things and everyone knew his place.
There were advocates of the Earth being round (indeed, going back to
Ancient Greece) but it suited most people in positions of leadership
to stick with the 'flat Earth' view. Then came the discovery that the
‘round view’ worked better in practice (we have to blame Columbus
and Magellan for this) and the flat-Earthers were slowly subjected to
more and more ridicule.

Apocalyptic long-term change

In this article we shall see how the
‘natural order of things’ in retail fund distribution as it
applied to the high-net-worth wealth-management market has been
turned upside-down because of the RDR but also through pressure from
an alternative way of thinking that had been gaining ground for a few
years beforehand.

Power in the value chain has now
shifted irrevocably from product-providers to distributors/advisor
firms, and the battle-lines between them have now been drawn up. The
short-term situation is full of noise and confusion and so demands
closer examination, but the forces in play now will cause apocalyptic
long-term change. The question arises: is the RDR the fund industry’s
version of the Big Bang? Have we gone from ‘flat Earth’ to ‘round
World?’

The historic value chain that ran
through the Nineties and most of the Noughties was effectively
controlled by product-providers. The reason is simple: bundled
charging. By acting as ‘factors’ for the entire value chain, the
providers dictated the prices that the customer paid and distributed
the resulting revenues all over that chain.

Although there was room for some
negotiation over fees, the capping of total revenues through annual
management fees (plus some additional expenses for administration) at
a typical 1.50% meant that each participant had to take a share of
each fee. The market norm became 75bps to the manager, 25bps to any
platform and 50bps to the advisor, regardless of the relative value
that each party might be 'adding' on the customer's behalf (1 basis
point or bp being 0.01% of the fees that the client pays or, as we
are looking at the past, paid).

Competitive behaviour, such as it was,
revolved around relative fund performance and star fund managers.
Even when the combined total costs of funds-of-funds packages in bps
ran into the high 200s, price competition was of little importance.

The Old World value chain

What were the key characteristics of
this 'world as we knew it'? Distribution was highly fractured and
there were plenty of small advisory firms. Only the clearing banks
and a handful of national firms wielded much bargaining power. There
existed a limited number of centralised professional fund-buyers,
largely in the form of funds-of-funds or private client firms, which
meant that all fund companies could hope for support from someone,
rather than flows being concentrated into a handful of
well-researched ‘mega-funds’ in key sectors.

Passive funds were used occasionally
and made up less than 8% of the Investment Management Association
(IMA) universe. It was a market dominated by sales and marketing
‘push’ strategies. The fund managers were the kings and the
people who could sell a lot of 'product' were at least princes.

As insured products fell in popularity,
fund management companies were seen as 'the good guys,' largely in
contrast with the insurance companies and banks which were seen as
'the bad guys.' Fund firms, which were numerous, were well-regarded
partly because they had done nothing actually evil, partly because
they were (allegedly) skilled, and partly because by choosing between
assets they injected a measure of objectivity into the market. They
had a reputation for probity that lasts in some measure to this day
and they were not involved in scandals and frauds.

Notes to Figure 1.

The old-style sales model, prevalent
before the RDR, was already breaking down but still recognisable a
year or two ago. This is – or rather was – the old 'push' model
in transit. The product-providers pushed their products out into the
market and a grateful audience ate them up. To put it another way,
the PPs decided what was going to go to market, they forced it
through the channels on this diagram and clients accepted it because
there was nothing else available. If the products were not
sufficiently popular they failed, but the whole process was
determined by 'push' factors from the suppliers and not the 'pull'
factors of demand.

At the bottom of Figure 1 (in the
large, amorphous bubble) are the traditional services – custodial
services, transfer agency services, fund accounting – that a host
of people performed for the asset-manager. To these we can add
trusteeship services, performed by a trustee in the case of a unit
trust and by an ACD or authorised corporate director in the case of
an OEIC (open-ended investment company). The transfer agency looked
after the register which said who owned this-or-that unit. It
registered any change that happened, e.g. someone receiving a
dividend, someone putting money in or someone taking it out.

Fund accounting was normally the
province of a third-party administrator but sometimes the fund
management company performed that service in-house. The providers of
these services typically charged their recipient, the fund management
firm, the total expense ratio – a calculation that added the annual
management charge (AMC) to the additional expenses as seen in the
Report and Accounts. The Financial Conduct Authority is now thinking
of cutting fees for this sector, or at least insisting on greater
clarity regarding the roles of the various participants.

The asset-manager then provided
services to the next stage in the value chain – the fund – and
more or less determined its own price for it along the way. Its
charges stemmed largely from a 'going rate' that the market set and
typically totalled 150 bps. Competition was simply not a factor in
the setting of this charge; market comparison operated here rather
than market forces.

The fund's income – which came from
the client paying it an AMC of 150 bps – is invisible on this chart.

The platform acted as the collecting
agent of fees from many fund groups (though there is only one on the
chart) for the independent financial advisor (IFA). It was also the
'aggregator' of deals – if a high-net-worth customer told his
advisor that he wanted to buy five funds, the platform would do it
through EMX, the electronic fund messaging system. The sales
typically passed through 75 bps, of which the platform kept 25 and
the IFA kept 50. The fund paid the platform its commission, which was
known as a rebate.

The platform, in turn, was basically an
aggregated dealing service. It provided a single point of valuation
for the distributor group, to which it passed a commission onwards.
The distributor group was solely there to collect IFA fees. An IFA
and its distributor group were the same thing monetarily but many
IFAs usually sheltered under one distributor group. St James' Place
is one example of such a group. Others are Sesame Bankhall, Simply
Finance, Intrinsic, 360, True Potential and Positive Solutions.

Lastly we come to the advisor, whom the
distributor group hosted. The advisor was really at the wrong end of
the chain. He sometimes worked on the client to push him into buying
this-or-that product or fund in accordance with his own interests and
nobody else's. Many supposed IFAs were really tied agents.

All change!

This all seemed to work well, at least
for some, yet the strains were already showing by 2011. Some advisors
were moving to holistic planning and charging fees for services to
clients outside the 50bps trail fee (the continuing commission
payment but not the initial commission payment or introduction
payment) approach we mentioned earlier. Most importantly, fund
supermarkets and wrap platforms had emerged to separate
('disintermediate') fund managers from distributors and clients and
to challenge the mechanism of control over revenue streams that had
been wrapped up in the AMC-based model. 'Disintermediation' was a
massive change: on the old model, when someone dealt with a fund
company their name went onto its records, whereas nowadays the fund
just deals with a platform without knowing who they are.

A growing handful of key distributors
also managed to press for and secure ‘special terms’ in the form
of additional private rebates, a practice that had previously been
limited to a couple of life companies or certain mass distribution
agreements. Were fund managers already losing control of the value
chain?

Underlying trends were eroding the old
world model, but the credit crunch of 2008 and poor investment
returns were also undermining confidence in fund management. Fund
managers were slipping from their place as ‘good guys’ and
acquiring a reputation for being part of the problem. The RDR and the
advent of full transparency coincided to break the old model forever.
Membership of the old Flat Earth Society was about to become a
drawback.

The second chapter of this two-part
article will contain a diagram of the investment management world as
it is now.

Simon Ellis

Principal

Strategies in Asset Management Ltd.

simon.ellis06@ntlworld.com