Asset management: Current Challenges and the hedge funds debate
Speech by John Tiner, Chief Executive
FSA Annual Asset Management Conference, London
19 September 2005
Introduction
The asset management industry is a cornerstone of the British financial services marketplace with around £3 trillion in assets being managed inside the UK. This makes the UK the 3rd largest country in the global industry after US and Japan, with about 7% of global assets.
The UK industry enjoys rich diversity, but with critical mass in each of its main components. The numbers are impressive: Defined Benefit Pension schemes continue to be a mainstay of the industry with over £1,000bn in assets under management. We estimate that unit-linked life and pension funds have grown to over £400bn surpassing with-profits life and pension funds which are just under £400bn. Authorised collective investment schemes (CIS) continued to recover in 2004, to reach £308bn by July 2005 and Investment Trusts had total assets of around £60bn by the middle of this year. The value of private client assets under management in the UK (covering execution only, discretionary and advisory portfolios) stood at around £300bn at the end of 2004 and industry sources indicate client confidence is improving in this important sector. And finally, the fastest growing area, hedge funds – where assets managed from London are estimated to have more than tripled in the past 3 years from $61bn to $190bn. Close to three-quarters of European hedge fund assets are managed from London.
And, as the most international financial centre in the world, UK-based firms provide a host of asset management services to global owners of assets generating 10% of the increasingly important net exports of financial services of this country. This impressive array of market statistics evidence the fact that London is the world's premier international financial centre and explains why so many of the key decision makers in transactions in global market instruments are located here. And they in turn ensure that London is the major location of investment banks and other service providers offering a range of global products and services.
With such a substantial sector in aggregate it is perhaps a surprise that the UK asset management industry does not always have the impact it could have in Europe and with the UK government. This is perhaps due to its more fragmented nature. We have tried to bring the whole industry together at this conference and host a biannual trade body forum to identify common regulatory issues. I am pleased to see speakers coming together from the institutional and retail players, the insurance industry, the private client investment managers and the hedge fund managers. I should like to thank our speakers for participating in this conference.
Better regulation / deregulation agenda
We read with interest the views contained in the OXERA report published earlier this year on the regulatory environment for asset managers in UK. The report makes it very clear that core asset management activities are very firmly rooted in the UK and are likely, in the view of the survey respondents, to remain here. Marketing and distribution also look firmly settled here as well. Respondents were slightly less sure about the location of back and middle office activities. So while this conveys a positive message which the FSA welcomes, we are acutely aware that the strongly competitive position of the United Kingdom cannot and must not be taken for granted, especially in a world where capital, skills and technology are increasingly mobile, and competition among regulators to create the most attractive environment is alive and kicking. Hence we take very seriously the messages in the report about regulation. The report states that "For the most part the UK regulatory regime is regarded as favourable". But a series of issues were raised, including concerns about how regulation may develop, and I am acutely aware of the growing chorus of concern about the cost and burden of regulation. I have been concerned about this issue from the day I became CEO 2 years ago, and I was able to elucidate some of my concerns and plans in a speech at the Mansion House on my second day in the job.
Since then, Better Regulation has become a political imperative to keep UK businesses competitive internationally. During the last 2 to 3 years we have worked hard to deliver Better Regulation across the full range of our regulatory activities, but I accept there is more to be done.
We have announced recently the methodology Deloittes will be utilising in their work to determine the costs of FSA regulation for UK firms. As part of this study and, to my knowledge for the first time ever on an independent basis and with a credible methodology, the regulatory costs incurred by institutional fund managers and financial advisers will be determined. In conjunction with our Practitioner Panel, we aim to gauge the full cost to financial firms of compliance with regulation under the Financial Services and Markets Act by isolating those costs that are incurred solely as a result of the Act from those costs that firms would incur even if regulation were not in place. Firms will be invited to attend workshops and interviews, and requested to provide data. I must emphasise that this project is not an end in itself. We will use it in conjunction with our review of the handbook and regulatory reporting requirements to identify requirements where the costs you incur are not justified by the benefits. We then have an obligation to remove those requirements and you should hold us to account for doing that.
Within the constraints imposed by weighty EU legislation and in the light of our obligation to regulate in a way which satisfies our FSMA objectives we are pursuing a deregulation agenda. Let me give three examples which relate to authorised Collective Investment Schemes, which are subject to the heaviest product regulation.
Firstly, the substantial overhaul of the CIS sourcebook led to major market liberalisations, with which I am sure you are familiar. Secondly, we have recently dispensed with the specific requirement to publish unit prices in a UK national newspaper. Thirdly, we know that asset managers have been eagerly awaiting an indication from us on how authorised collective investment schemes are to be priced in future. Our COLL sourcebook, which will be mandatory for all schemes in February 2007, only allows for single pricing. At the moment there is a choice for the manager in the pricing of authorised unit trusts - they can be either single or dual priced. Investment Companies with Variable Capital (ICVCs) have, of course, always been single priced. We have said however that we would look again at this pricing question before the COLL sourcebook becomes mandatory. We realise that we need to do so early enough to enable managers to prepare for the position that will apply after February 2007.
We will be consulting on this issue in the second quarter of 2006. Our starting point will be that dual pricing should be available for both authorised unit trusts as well as ICVCs. This is on the basis that the industry has for some time operated single and dual priced funds alongside each other without apparent consumer detriment. In practice, our policy would therefore mean that dual priced unit trusts would be able to continue as before. It also implies that ICVCs would be able to dual price for the first time.
While you would expect me to keep an open mind in what the outcome of the consultation might be, my message to dual pricing managers is, therefore, that there is no regulatory need at this time to change over to single pricing.
I must also stress that the pricing question is not a valid reason for a manager not migrating from the CIS sourcebook to COLL. There is already a waiver modification available on request which enables dual pricing under COLL. I hope that managers will make the move to COLL as soon as is convenient to them - my CIS Authorisations team is keen to avoid a log-jam of conversions at the end of the transitional period.
A further, more general example is that we are taking the opportunity offered by MiFID to consider a much more fundamental review of our Conduct of Business Sourcebook on the retail side, with a view to significant simplification. You may recall that most of the existing Conduct of Business requirements on the retail side are amalgamations of the pre-FSA rulebooks. They were not subject to cost-benefit analysis or fundamental review at N2 – there just was not time or capacity either in the FSA or the industry to undertake that. MiFID affects so many areas in the retail regime, that it makes sense, we think, to see whether we can create a sourcebook that is more in keeping with the FSA's strict policy making criteria of today – that market failure and cost benefit tests demonstrate clearly that intervention is justified and that FSA regulation is the most effective form of intervention.
In summary, I am determined that these deregulation efforts are part of a drive to establish more clearly the linkages between the costs and benefits of our regulation.
TCF
As the contribution to total UK AUM from Defined Benefit schemes gradually declines over the next few years, the UK asset management industry will become increasingly more reliant on the growth of cash flows in other types of asset management mandates. There is also a great opportunity for your industry arising from the Government's reform of the pensions system, and I see from the FT this morning that Dick Saunders is discussing this later today. Against this background, we note the ongoing disappointment in the sales of retail investment products. Although the value of retail funds has increased since 2000, product sales have disappointed, most recently in the first quarter's ISA season. Investors continue to be wary of equities following the deep bear market of 2000 to 2003. But with UK equities markets up 26% in the last 2 years, there must be other factors which are keeping investors shy. Complexity may be one factor; but the public's confidence in investments products generally and in the firms that manufacture and distribute them, has been dented and needs to be rebuilt for the future health of the long-term savings industry. We believe that our work under the banner of treating customers fairly, or TCF as it has inevitably been branded, is an important initiative which has sparked a great deal of interest and indeed some concern in the industry.
For instance, the pitfalls in design of certain products have attracted considerable regulatory effort over recent years. Most recently, so-called precipice bonds and split-capital investment trusts have highlighted the downside risks of serious mis-matches between product characteristics and consumer needs. In our discussions with firms about how to avoid these disconnects, we have identified a number of good practice principles that can mitigate the risk of this mismatch.
For example, firms are using a range of techniques to test:
- whether the products they are designing meet the needs of the target customers;
- whether target customers would be likely to understand the product’s features;
- how the features of the product can best be made understandable to the target customers; and
- how the product would perform through a range of stress testing scenarios.
By incorporating this kind of testing at the production stage, firms can identify that the right safeguards are built into the sales and after-sales processes, or even withdraw the product from sale altogether if need be. At the very least, we do not think it is unreasonable or over-ambitious to expect firms to deliver outcomes that avoid the systematic mismatches of product features and customer needs that we have witnessed in the past.
I hope you are all well-aware that the FSA has placed increasing emphasis on product marketing. I took the decision when I was appointed as Chief Executive that we needed to boost considerably our resources dedicated to reviewing advertisements across all relevant media, looking for evidence of good and poor practice, with the aim of promoting the former and stamping out the latter. Our Financial Promotions department of 30 staff consider whether marketing material represents a clear, concise and balanced communication of risks and rewards to consumers. The team maintains several dedicated pages on our website which I would commend to you. These contain updates on current issues in Financial Promotions as well as examples of good and bad practice in product marketing material.
The most common point of sale for investment products manufactured by asset managers is at the client/advisor interface. I am conscious that the large majority of you will have no direct involvement in this relationship, but that does not mean that you should have no interest in or that you have no exposure at the point of sale. There are multiple regulatory risks that arise at the interface which require careful management.
Over the next year we will be carrying out further analysis to clarify the division of responsibilities between product producers and product distributors. In particular, we will consider the implications of the High Court case, Seymour vs. Ockwell, in which it was held that a marketing company must share liability to the end consumer with an adviser. We will review the extent to which product providers can abrogate their responsibility for products, particularly when their performance may be highly susceptible to variability in different market environments. Irrespective of the outcome of this analysis, firms would be well advised to think carefully about different advisers' abilities understand and explain product features. Time taken to consider properly the distribution of products by their manufacturers will go a long way towards mitigating the risk of the products ending up in the hands of consumers for whom they are not suitable.
EU Developments
The pace and content of policy making and regulation is to a large extent now driven by Brussels, not by the UK government or the FSA. Though we have held true to our commitment to reducing the number of CPs we issue – nearly halving the number last year and aiming to keep to that much reduced level this year – there are still major strides to be taken in the implementation of the Financial Services Action Plan.
As I mentioned earlier, the greatest changes will result from the introduction of the Markets in Financial Instruments Directive (MIFID). This will establish EU-wide standards in core policy areas for investment businesses, such as client classification, financial promotions, outsourcing and best execution, to name just a few. This will result in significant changes to our Conduct of Business Sourcebook
You will be aware I hope of the recommendations of the Expert Group on consistent treatment of UCITS transitional provisions, which were agreed by CESR in its advice to the Commission, and which, after consultation, were published recently. These recommendations will require some technical amendments to our COLL Sourcebook which we will be consulting on very soon. In the meantime, I urge all managers of UCITS which are being or are intended to be offered on a cross-border basis, to familiarise yourselves with these new transitional arrangements and to prepare to comply with them. We, of course, will follow our usual process disciplines in bringing these changes into force, but I would not expect there to be significant alteration to the CESR recommendations.
There are two further items of interest on the CESR Expert Group’s agenda: clarification of certain key definitions in the UCITS directive, and simplification and harmonisation of registration procedures. The definitional work is focusing on aspects of eligible securities including closed end funds, and the treatment of embedded derivatives and structured financial instruments. I would also mention potentially important work on the simplification of UCITS registration procedures across Europe. As many in the audience will know, the process for registering a UCIT varies hugely across Europe. We are working hard in the Expert Group to get to the bottom of these differences and to try to streamline the processes.
As you no doubt know, in July the Commission published a "Green Paper" on asset management. This offers policy options and an indication of the priority with which the Commission views those options. In the near term, the Commission sees no case for major legislative change and has listened to industry calls for a slowdown in the pace of regulatory change. However, it has begun a process of dialogue with stakeholders about whether (and if necessary, how) to modify the European framework for funds so that it better reflects the need to balance a varied range of investment strategies with the objective of protecting the investor. In this context the Commission has examined the viability of a true management company passport and considered whether procedures to allow fund mergers and pooling will deliver worthwhile benefits such as economies of scale. It is absolutely essential that all those of you who are affected engage either directly or indirectly through the IMA with this work.
Unit-linked funds
We have a concern, which we mentioned in this year's Financial Risk Outlook, that deficiencies in the operation of unit-linked funds – such as the pricing of units – could cause customer detriment and undermine confidence in the market. We have been reviewing whether firms’ controls in this area are satisfactory, and will consider whether standards need to improve, and if so, how that might be achieved.
Last year we visited a number of firms to look at, among other things, their controls over unit pricing. We found that there appeared to be less standardised pricing policies and procedures, less oversight and governance, and more opportunity for the exercise of discretion by the insurer than would be the case for an operator of a CIS. We also found that most of the firms had experienced attempts to market time their funds (i.e. policyholders exploiting the pricing times of the unit-linked funds to deal with knowledge of subsequent market movements to make gains).
To test these findings and widen the sample we sent a questionnaire to a further 14 firms. These were larger firms so that our work has covered the funds held by the majority of policyholders. The results of those questionnaires broadly supported our earlier findings.
Probably the main reason for this disparity in practices is that the unit linked sector has not been subject to regulatory standards over its pricing policies, procedures and oversight. Some firms have recognised this gap and have looked to apply the standards that apply to unit trusts. Others, when asked, have suggested that some form of industry guidance would be helpful to bring some consistency to this sector (you will not be surprised to hear that there was not a majority call for detailed regulation). To help remedy this position we are working constructively with the ABI to produce some guidelines for unit linked funds, which we expect to improve pricing standards, transparency and fairness. Once these are in place we will be in a better position to monitor a firm's activities in the UK sector and take appropriate action if necessary.
A second strand of this work is to look at the transparency of UL funds against CIS. We often see disclosure to customers, or the publication of information on policies and practices as a good counterweight to the informational advantages and discretions of the product provider. While we are aware that there are structural differences between CIS and UL funds, we are obliged by the FSMA to have regard to the need to minimise the adverse effects on competition from anything done to discharge our functions, and to facilitate competition. We are working to understand the differences in the information available to customers for both products and to decide if there are good reasons why we should address any differences. This work will take the UL industry's raising standards initiative into account.
Investment Trusts- The Listing Review
I would now like to move on to another retail investment product, namely investment trusts. I would like to take this opportunity to describe an important piece of work that we are engaged in concerning listed investment entities. Within the existing Listing Rules we have two standalone chapters that cover the entire population of listed investment funds in the UK, including both open and closed ended investment funds. These are Chapter 15 – Investment Entities and Chapter 16 - Venture Capital Trusts.
Apart from changes to these rules in April 2004 to address specific concerns over the activities of split capital investment trusts (especially the prevalence of cross holdings), there has not been a comprehensive review of this regime for many years. The new Listing Rules that were introduced on 1 July did not include any policy changes to rules for listed investment entities, as we decided that this work was important enough to warrant being undertaken separately.
This work has now begun and we are reviewing the requirements from first principles, taking into account our objectives to provide an appropriate level of protection for investors in listed securities, facilitate access to listed markets and maintain the integrity and competitiveness of UK markets for listed securities.
This will be a challenging exercise. The investment management industry has moved on since the current rules were first introduced and managers today employ a much wider array of techniques and strategies than they once did. This exercise will inevitably touch on whether we should now open up the listing regime to companies employing a broader range of structures and investment strategies than we currently do and whether any additional safeguards would be needed if we did.
There will of course be a full consultation process and respondents will be given the opportunity to comment on any new proposals then. However, into help us shape our proposals, my colleagues from the UKLA are presently canvassing views on an informal basis with the trade bodies in one we would be delighted to hear from firms and others directly and I would ask that you contact Andrew McLeod, who is managing this project.
Soft/unbundling
I am pleased to say that the ongoing developments on soft commission and bundled brokerage have passed another major milestone. We finalised our rules in July.
Now we need to turn our attention to the impact on retail investors, in particular those invested through CIS, investment trust and with-profits and unit linked life and pensions products. Typically these investment funds bear the brokerage costs of dealing in their assets. While in most cases the amounts in relation to soft commission and bundled brokerage are probably not significant, it would be wrong if the result of requiring disclosure by the investment manager to institutional customers was to chase the allocation of soft commission and bundled brokerage into retail products, and for these to see an increase in costs as a result. This presents a slight problem, as we think it would be inappropriate for retail investors to receive disclosure intended for institutional investors. It would be costly to produce and disseminate such information to retail investors and would, we think, be difficult for investors to properly evaluate and make use of them. We are conscious of the danger of overloading retail consumers with information.
We could require that the disclosure information - in its entirety or just in summary - is made available publicly to informed parties, such as advisors, pension fund consultants, journalists and academic researchers. The purpose would be to highlight those fund managers reporting soft commission levels amounts over the market norm. Alternatively we could introduce an "investors' champion" for retail funds to receive and consider the disclosure and hold the fund manager accountable for his expenditure of investors' assets. For CISs and Investment Trusts this role seems naturally to fall to the trustee and the IT board respectively. Life companies are slightly different, although we could build on the concept we introduced in our guidance on PPFMs, to allocate responsibility for this role.
So what do we intend to do? As we committed in our 2005/6 Business plan we will begin consulting shortly on how these reforms can best be applied for the benefit of retail investors.
Hedge Funds
As mentioned earlier the fastest growing area in asset management has been hedge funds. The mainstream sector is developing with some organisations building up significant businesses and, as our authorisations department can testify, a specialist boutique manager sector is flourishing. Many of them are located in well-heeled addresses a few miles north of this conference centre.
Hedge funds are growing in importance in terms of their contribution to financial markets. They are a major source of liquidity and can significantly enhance market efficiency. While it is estimated that hedge funds only account for less 5% of total assets under management worldwide, they are at present estimated to account for between a third and a half of daily activity on the New York Stock Exchange (NYSE) and the London Stock Exchange (LSE). They are increasingly fundamental to the efficient reallocation of capital and risk. They can also provide a mechanism for increasing investment portfolio diversification. Hedge funds no longer seem quite so 'alternative' but rather seem like a core component of a modern and dynamic market place. A significant development has been the growing impact of hedge funds on the revenues of investment banks.
Returning to the themes outlined at the beginning of my speech in relation to the asset management sector as a whole, the FSA recognises that it would not be beneficial if regulatory action caused the hedge fund industry to move to more lightly regulated jurisdictions, both from the point of view of the asset management industry and the importance of London as a global financial centre. Our regular 'hedge funds as counterparties' survey has shown London to be a global centre for prime brokerage. A recent report has estimated that bank revenues from hedge funds were up to around $25bn in 2004, or an eighth of their total revenues. Of this total, it is estimated that $19bn was generated from trading and sales business with the remaining $6bn coming from prime brokerage.
However, there are benefits to ensuring that we operate an informed, transparent and proportionate regulatory environment here in the UK. To achieve this in a structured and informed way, we published in June two discussion papers that focus on related but separate aspects of hedge funds and retail investment products. The papers look, respectively, at the impact of hedge funds on the UK's wholesale markets - Hedge Funds: A Discussion of Risk and Regulatory Engagement – and at the regulatory regime that applies to retail investment products - Wider Range of Retail Investment Products: Consumer Protection in a Rapidly Changing World.
My colleague Hector Sants will cover the issues raised in the DPs in more depth in the afternoon session.
The UK financial services industry has unrivalled depth, diversity and expertise and there are many opportunities ahead to be derived from the development of the EU Single Market, the upcoming changes to pensions legislation and most crucially from winning back the confidence of investors
I have outlined some areas where we could deregulate and where we have concerns. The bottom line is that we adopt a common sense approach and work with the industry to serve a better market for participants and their customers.