FSA view - Regulatory Risks and Priorities for 2005
2005 2004 2003 2002 2001 2000 1999 1998 1997
Speech by Dan Waters
Asset Management Sector Leader
IEA'S 6th Annual 'Future of Fund Management' Conference
Good morning ladies and gentlemen. I am delighted to join you at this important and well established annual gathering of asset management industry leaders. I do so wearing my FSA Asset Management Sector Leader hat.
The FRO, the IRO and the Business Plan
As billed, I intend to cover the important topic of the Regulatory Risks and Priorities for 2005 that the FSA sees in respect of the asset management industry. This speech is based around the views outlined in three documents we recently published to explain to our external stakeholders how we approach our work in the coming year.
Firstly, the 'Financial Risk Outlook', which sets out the risks in the external environment which we are particularly concerned about both in the near and longer term. Secondly, the 'International Regulatory Outlook', where for the first time we set out the main EU and international regulatory initiatives and how we expect these to affect our work and our stakeholders. We will be very interested to hear your views on the usefulness of this new publication.
And last but by no means least the Business Plan for 2005/06. This explains our main priorities for the coming year, the timing of major projects and the resources we need to do the work. In our Annual Report for 2005/06 we will set out clearly how we have performed against this Plan. Doubtless there will be some divergence between Plan and outturn; we will need to adjust our plans and priorities in response to events as they unfold. This year we set out our plans under three main aims – promoting efficient, orderly and fair financial markets; helping retail consumers achieve a fair deal; and improving our business capability and effectiveness.
The importance of asset management to the UK
The Financial Risk Outlook has a separate section devoted to Asset Management and I commend it to you. The sector continues to grow, and is of crucial importance to the long-term financial well being of this country. It is difficult to be precise but there is no doubt that total funds under management in the UK comfortably exceeded £2,000bn at the end of 2004. UK Defined Benefit Pension funds continue to form the largest segment of UK assets under management, amounting to an estimated £700bn. Unit-linked life and pension funds grew to over £400bn by mid 2004 surpassing with-profits life and pension funds at around £370bn. Authorized collective investment schemes (CIS)(unit trusts and OEICS), supported by the recovery in equity prices, continued to recover in 2004, to £275bn by December 2004 from a low-point of £184bn in January 2003. Investment Trusts had total assets over £60bn by January 2005. 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. The booming hedge fund sector was estimated to be approaching £100bn worth of UK-managed assets at the end of 2004. However, this sector is the most difficult to measure as third party data providers tend to look at the global or regional level rather than by country.
The equity market downturn of 2000-03 put UK asset managers’ profit margins under pressure. In response to this challenging business environment, many fund managers have made continued efforts to cut costs. There is evidence (based on reports from a sample of larger firms) that margins have now stabilised, albeit below the levels of 2000.¹ However, those fund managers that have not yet been able to respond to the changing environment continue to face pressures on their businesses.
The steady decline of Defined Benefit Pension Schemes
The landscape is changing in other ways. The relative dominance of defined benefit pension funds is diminishing. Most schemes are closed to new members, so as the beneficiaries reach retirement and take their well earned pensions, the schemes slowly diminish. This has consequences as UK pension funds have historically allocated a high proportion of their assets to equities, relative to the US, Japan and other European countries, with a 71% equity allocation in 2000. However, this percentage has been falling as pension funds have switched assets into fixed income securities, and by 2003 equity allocation had fallen to 56%. Accounting changes (the introduction of FRS17) and the increase in the average age of defined benefit pension scheme members (given that many of these schemes are closed to new members) mean that this downward trend is likely to continue. The large size of pension funds relative to the market as a whole means that this transition could have a sustained market impact.
Against this backdrop of industry, a number of key sectoral risks emerge on which I and I hope you will be keeping an increasingly watchful eye. I will touch on some of the major areas of concern in the rest of my remarks. These issues feature in our Business Plan and indeed in the International Regulatory Outlook, and I encourage you to read them for more detail.
Fragile Consumer Confidence and Treating Customers Fairly
Although global equity markets experienced a moderate recovery in 2004, consumer confidence, which was depressed by market underperformance in the earlier part of the decade, appears to be taking some time to recover. The recovery in sales of retail authorized collective investment schemes following the equity bear market of 2000-2003 has however been hesitant, probably indicating continued fragility in consumer confidence in investment products. For asset managers, a lack of confidence means that consumers may save and invest less, which limits growth in revenues and profitability. As well as representing a risk to the financial performance of firms, lack of consumer confidence presents a risk to our objectives, because consumers are less likely to take advantage of the services the sector can provide. This is a particular concern in the context of the ‘savings gap’ and increasing individual responsibility for financial provision.
We believe that the fair treatment of consumers by firms (and its perception as such) can contribute a great deal to the rebuilding and maintaining of consumer confidence in long term savings products. In some areas, such as advising customers and discretionary portfolio management, the risks regarding fair treatment are well understood. But risks can also arise in other areas, for instance if firms do not have adequate complaints handling procedures or if charging structures are not transparent and understandable. And there are also risks to fair treatment of customers arising from parts of the industry which do not have direct contact with consumers – for example, if product providers are not clear about the intended target market for new products or fail to communicate this to distributors, mis-selling risks may be higher.
Many consumers are seeking alternatives to equity investment products, including funds investing in corporate bond and property markets. This is being driven by the poor recent performance of many equity funds, and the ‘search for yield’. Structured investment products, including those offering capital guarantees, have proved particularly popular over the last year, with the number of new launches each month trending upwards. There is a risk that consumers may not fully understand how complex structures work. Indeed advisors may find them difficult to explain. For example, the ‘upside’ offered by some capital guaranteed products can be severely limited where the risk capital invested performs poorly at the outset. In some products, investors may not receive dividend income in exchange for capital guarantees. If consumers do not understand the key facts about the products they have purchased, there are likely to be tears ahead.
The outsourcing of CIS administration keeps growing
There has also been continued growth in the outsourcing of CIS administration. Our recent survey found that 84 small and medium-sized fund managers out of a sample of 100 had outsourced some of their administration functions. A number of larger firms have outsourced administration and transferred their own staff to the Third Party Administrator in the process. Firms operating in the US market tend to outsource more of their functions than UK asset managers, suggesting that there may be scope for this trend to continue.
While outsourcing can result in service and efficiency improvements, there are risks at the point of transfer to the external supplier, and on an ongoing basis, particularly with regard to unit pricing and dealing. Because third party administrators service a wide range of funds for different managers, problems arising in an individual administrator can also have a more widespread impact. Firms’ ability to comply with their regulatory obligations may also be reduced when they become dependent upon the effectiveness of external suppliers’ systems and controls. The impact of operational failures is likely to be greater if firms do not have robust contracts and service-level agreements in place. At the same time, we are conscious of the burden on third party administrators arising from oversight arrangements conducted by numerous clients and other third parties. This is an area where an industry-led solution could lead to a more efficient but still robust process of oversight of third party administration activities.
The anomalous position of Unit-linked administration
Risks may arise too in the administration and control of unit-linked life funds. While unit-linked funds are similar in nature to Collective Investment Schemes and indeed in many respects compete with them, the regulations surrounding pricing and dealing are less prescriptive, and the attention paid to them by regulators in the past has been far less. As already mentioned, unit-linked life and pension funds have greater assets invested than CIS and have recently surpassed with-profits life and pension funds. Deficiencies in pricing units could cause consumer detriment and undermine confidence in the market. We have been reviewing whether firms’ controls in this area are satisfactory, and will consider (in consultation with interested stakeholders) whether standards need to improve, and if so, how that might be achieved.
The Hedge Funds "Gold Rush"
The industry hotspot has continued to be Hedge Funds. Weaker performance especially during the middle part of the year does not appear to have had an adverse effect on inflows. Eurohedge estimates there were just over 250 new European hedge funds launched during 2004, and they raised combined total assets of well over $22bn, according to their annual survey of new funds. This compares to $21bn raised by the 228 new funds of 2003. (European hedge funds are here defined as those whose manger has its main head office in Europe).
The direct involvement of existing financial institutions in managing hedge funds is also increasing, with traditional asset management groups and banks acquiring hedge funds or establishing ‘in-house’ hedge funds. Firms are aiming to offer a wider range of investment products to their customers, and at the same time offer talented investment managers and traders opportunities that might otherwise only be available in a specialist fund environment. There can be, however, significant management and regulatory risks arising from these hybrid arrangements, which fund management firms must recognize and mitigate.
For example, significant market and reputational risks could arise in the event of problems with in-house funds, or even funds in which a firm has third-party involvement. Investment banks and asset managers need to manage carefully issues of disclosure and potential conflicts of interest. These include where a long-only asset management firm also manages hedge funds. Conflicts can arise for example when a hedge fund effects short sales of securities, if such securities are held by long-only funds managed by the same advisory firm. Hedge fund managers’ incentives can also be influenced by performance-based compensation structures.
The bottom line is that these and other conflicts must be recognized and managed in a manner that ensures that all the firms’ clients are treated fairly.
As the profile of hedge funds grows it is likely that consumers’ interest in alternative investments will increase and some fund managers will seek to meet this demand. It is clear that the line between what can and cannot be offered to private customers is becoming blurry, and that we are not in standing-still mode in Europe on the whole question of wider access to hedge fund investments. The Committee of European Securities Regulators has formed an Expert Group on Investment Management, which is looking at a wide range of issues, including the question of harmonisation of the treatment of unregulated collective investment schemes. This will feed into a Green Paper being prepared by the European Commission for the autumn, which will address a wide range of asset management issues, including the treatment of hedge funds. In my view this is extremely unlikely to end up in a ‘no change’ solution.
As announced in our Business Plan, we will be publishing a discussion paper on the sensitive issue of wider retail access to alternative investments. The obvious challenge is trying to square the circle between wider access, and the need to ensure adequate consumer protection, in circumstances where consumer knowledge and confidence can be low, and the risks and complexity of products can be high.
Commentators point out the difference between single hedge funds with their high performance / high risk profile and the fund of fund products that some managers would like to offer to the retail market. These funds of hedge funds foreswear the high risk/return game, and instead seek to use derivatives and quantitative analysis to deliver more predictable, absolute returns. In principle this sounds an attractive proposition for the mainstream, risk-averse retail market. But are retail consumers, or some of them, in a position to understand the risk profiles and performance characteristics of these vehicles sufficiently well not to be surprised and disappointed if things do not turn out as hoped?
Our review will consider these changing trends, and will also look at the treatment of these issues in other EU member states, and in the emerging debate on possible European legislation. Please do not assume that because we are reviewing the current regime, we have decided to seek a dramatic change in the current arrangements. We approach the analysis with an open mind. Also keep in mind that the ban that exists on the promotion of hedge funds to the retail public can only be changed by an amendment to the Financial Promotions Order, which of course is a matter for the Treasury. If our work should suggest, and if Treasury were to agree, that some liberalisation might be warranted, we would need to consider carefully appropriate consumer safeguards. These however might be difficult to design without in effect reverse-engineering into product regulation of hedge funds, which we do not find an attractive proposition. We will continue an open dialogue on these difficult issues with the industry, consumers and other stakeholders.
Fund Governance
The issue of fund governance has been receiving significant attention lately, prompted to a large degree by revelations about conflicts of interest at US mutual funds during 2003 and a series of initiatives by the SEC subsequently to address governance and transparency. IOSCO's Standing Committee on Investment Management has approved a mandate that will require its members (who together cover all the major developed economies) to examine in detail the arrangements surrounding the governance of retail investment funds. In this regard, I commend to you the IMA’s extensive review of CIS fund governance issues, which has some quite important recommendations for fund managers and for the FSA as well. We will be considering those suggestions as we undertake our own work in the IOSCO context, and in respect of the implications for retail funds of the work we have been doing with the industry on softing and unbundling.
Soft commissions and unbundling
We are coming within sight of the finish line on the rather marathon-like enterprise of reviewing the practices associated with ‘soft’ commissions and the ‘bundling’ of research costs with brokerage charges. As has been accepted by all involved in this work, current practices in these areas can lead to conflicts of interest, and it is time for change. We are seeking both transparency in respect of execution and research, and a competitive market in the provision of broker-produced and independent research. We recognise that these are challenging issues for the industry to address, and are grateful to IMA, LIBA and NAPF for the efforts they have made in developing an enhanced disclosure regime to address our concerns. We will be issuing our response to that work, including feedback on our Policy Statement on the definition of execution services and research, in March. As announced in our Business Plan, we also expect to issue a Consultation Paper in Q3 2005 on how reforms in the area of soft commissions and bundled brokerage arrangements could best be applied more widely for the benefit of retail investors.
The European legislative agenda for asset management
I have already referred to the potential impact of the EU in the area of hedge funds, but there is a good deal more on the horizon in terms of asset management. Probably 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.
Indeed as you will see in the Business Plan, 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 in the FSA or indeed 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 principles-based, market-failure driven, proportionate philosophy of regulation.
As a backdrop to the emerging work on MiFID and other directives, it is helpful I think that there is now clear recognition within the European Commission that asset management should be treated as a defined sector. An example of this was the decision to set-up the CESR Expert Group on Investment Management that I mentioned earlier. This comprises senior regulatory officials in the asset management area from every EU member state. It replaced the old UCITS Contact Committee which quite frankly failed miserably to bring much needed consistency to the implementation of the UCITS directive across the EU. The remit of the CESR expert group is wide, in principle covering all asset management issues, ranging from individual portfolio management, to management of CIS, to the treatment of hedge funds and other non-harmonised collective investments.
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 with external stakeholders, were recently published. These recommendations will require some technical amendments to our COLL Sourcebook which we will be consulting on very soon, so look out please for that. 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. These are technically demanding and the discussions I will confess to you have been quite difficult. We are aiming to make our recommendations to CESR in a few weeks’ time. They will then be published for consultation, an opportunity for any interested party to provide input. I encourage those of you who are interested to get involved.
I would also mention potentially important work on the simplification of UCITS registration procedures across Europe. Those of you who are in this game will know that the process for registering a UCIT vary hugely across Europe in terms of the amount of time it takes, the cost and the complexity of the procedures. We will be working hard in the Expert Group to get to the bottom of these differences and to try to streamline the processes. I do not expect this to be an easy task.
Conclusion
I hope that this quick tour of the asset management regulatory horizon has been helpful, and will give you some pointers on what to expect and what to look out for and contribute to going forward. By communicating our agenda in as open and transparent a manner as we can, we hope to engage in constructive and forward-looking dialogue with you on key sector issues. Thanks for you kind attention and I hope that you find today’s conference interesting and useful.
¹ Pursuing profitability: securing the future, IBM Business Consulting Services, 2004.