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I am delighted to be here to open the fourth Annual FSA Asset Management Conference. The focus of our conference today is principally on regulatory issues on the retail side. We will be focusing on the emerging European funds agenda, including the important changes being made in the UCITS regime; on the impact of platforms on the retail market; and on the challenges of clarifying the responsibilities of providers and distributors of financial products. All of these have important implications for the fund management industry. And they need to be considered against the backdrop of our Retail Distribution Review.
I begin by emphasising the importance of the retail fund management industry in providing investment products to UK retail consumers. The fund management industry has a very important role to play in terms of developing and improving:
- the range of products and strategies in which consumers can invest;
- consumer understanding of the outcomes to be expected from investment products and strategies; and
- the ability of consumers to grasp the relative value of different products and to distinguish among providers and products for reasons that are sound.
So what role can an innovative and competitive fund management industry play in improving outcomes for consumers?
Market Developments
Recent market developments have highlighted the fragile nature of confidence and trust in financial institutions, and in particular in asset-backed vehicles and instruments. It is taking a long time to restore orderly market conditions, or indeed for some markets to operate at all. There are many factors at work here, and I will not add to the many explanations of how we reached the position we are in. But I would say that institutional investors need to play their full part in driving us towards better functioning markets, with better pricing of risk, not least through demanding greater transparency and clarity around the vehicles and assets in which they invest. Moreover, institutional investors need to be prepared to take investment decisions that take into account the risks – including risks to themselves - from poorly functioning and inefficient markets. If all market participants hoard liquidity, or cut lines to other market participants without adequate consideration, then we will not simply remain where we currently are but will find ourselves in an ever-worsening situation where the benefits from maturity transformation become increasingly difficult and expensive to deliver, and where financial services firms become increasingly vulnerable to shifts in sentiment and confidence.
Notwithstanding the current difficulties in global credit markets and their impact in particular upon the hedge fund sector, the UK asset management industry as a whole looks healthy. The latest IMA Annual Survey, published in July of this year, reported that the UK management industry was the second largest asset management industry in the world at the end of 2006, having during this period surpassed Japan for the first time. The survey reports that retail funds now represent around 21% of assets managed by IMA members, amounting to nearly £650bn at the end of 2006, out of total assets under management in the UK by IMA members of £3.1 trillion.
Of course attributing good health to the industry on the basis purely of growth in funds under management is a bit tricky. The problem with reliance on funds under management as a metric is that it rises and falls with the markets and can mask real growth or shrinkage in terms of new business. I am reminded of the difficulties in the insurance sector’s over-reliance on ‘new business’ as a measure of success, which ignores the significant degree of ‘churn’ in parts of that industry. That said, as far as it is possible to tell, it would appear that the retail funds sector has enjoyed a real increase in its share of total customer assets.
Our Retail Distribution Review suggests there remain significant challenges in the way in which the UK financial services industry, including the fund management industry, is meeting the needs of consumers. There is consensus throughout the financial services industry around Callum McCarthy’s assertion at Gleneagles last year that, essentially, the UK retail market is ‘broken’. The UK fund management industry is part of that broken model, and needs to play its part in mending it. So my challenge to you this morning is to recognise where the shortfalls are and to do something about them.
The position of the fund management industry in the UK retail market makes this a quite demanding challenge. Providers and manufacturers of financial products, including the fund management industry, have in some respects become divorced from direct relationships with end consumers, placing great reliance on a large population of financial advisers and other types of third party sales to achieve product distribution. This separation of the product creator from the end user presents a significant set of risks. It seems to me that we must improve the delivery of appropriate products to end consumers.
Fund Managers and the future of the retail market
The Retail Distribution Review vision is a market in which firms design, market and advise on good value products that meet genuine consumer needs. It is a market in which advisers are highly professional, impartial and properly capitalised. It is also a market in which more capable and confident consumers are better able to look after their own interests in dealing with firms that are committed to treating them fairly. Where do fund managers fit in this picture?
I do not agree with those who suggest that fund managers are simple product manufacturers who have no interest or obligations in respect of the consumers who end up owning their products. Indeed it would be very odd to suggest that fund managers, who hugely value and typically spend a great deal of money and effort building their brands and reputations, would be indifferent to where their products ended up or whether they performed as expected for those holding them. That sort of indifference would be a recipe for disaster.
Our Statement on the responsibilities of providers and distributors for the fair treatment of customers, which we will be exploring in the session just after my remarks, looks at some of the key issues around product design and the role that fund managers play in positioning their products. I anticipate this will prove a lively session. Without pre-empting that discussion, I do want to make a few high-level points.
Product design
One of the key elements of our Statement on provider and distributor responsibilities for fund managers is its focus on product design. You will no doubt explore this morning the issues around design and target markets, and the questions that follow from the need for the fund manager to follow through the value chain to assess whether expectations in respect of the target audience have been achieved. I want to focus for a moment on a related but different challenge - the design of products by fund managers that actually meet consumer needs rather than play to what consumers can be induced to buy. It might seem an odd distinction. Surely consumers would not purchase products that do not meet their needs? Sadly, in the retail financial market, where most investment products are actively sold and not bought, they often do.
I will not elaborate on the well-known market failures that characterise the retail market for investment products in the UK, which are all too evident in the analysis that underlies the Retail Distribution Review. We have a market where consumers struggle to understand their own needs and to meet them competently. Consumer wants are typically limited to a desire simply to "save", to put money away for the future, because they know they ought to. They frequently do not know what they need, and nor would it be appropriate, given the heterogeneity of consumers' needs, for a firm to simply tell them what they need. Alternatively, consumers might know what they need, but the need might conceivably be met by many different types of products or services.
Our perception is that investment products and services seem too often fashioned to meet the needs of providers and distributors, with consumer needs taking a back seat. You may say that the role of the product provider is simply to provide products that satisfy appetites at the time they are sold. It seems to me, however, that the traditional method of product creation in the fund management industry – designing products for which there is a perceived appetite, perhaps because the sector or theme has already attracted a significant amount of interest from other investors – is not one that always results in products that are geared to consumer needs. Indeed it can amount to jumping on the bandwagon, often as it is about to take a rather exciting plunge.
In articulating their vision of the "Asset Management Industry in 2010", published last year, McKinsey identified eight major trends that they believe will shape the US asset management industry over the coming years. While their research focused on the US market, I believe their views may have broader application to developed Western markets. Two trends seemed particularly relevant to the UK market.
First, the enormous change in the demographic balance of the population will mean that individual investors will increasingly be moving away from products geared to savings and accumulation towards decumulation products, which focus on income generation and capital protection. Protection products will, they suggest, be of particular interest, including those that focus on protection from adverse market performance, inflation movements and longevity risks. Products incorporating capital protection elements obviously look appealing to consumers in times such as these.
Second, McKinsey assert that the existing ‘style-based’ investment strategies offered by the asset management industry (by which they mean traditional fund strategies such as growth, cautious, balanced, etc.) are bad for investors, producing narrowly focused funds that typically underperform broader based strategies. Their conclusion is that the industry would be better advised to focus more on fashioning outcome-based rather than style-based products. US evidence suggests that funds built around meeting consumer needs and desired outcomes (such as retirement provision, tax minimisation and income generation) seem so far to be growing their customer bases at twice the rate of traditional funds.
Does Regulation inhibit innovation to meet consumer needs?
In addition to the Retail Distribution Review and our work on product provider and distributor responsibilities, which together challenge fund managers to design products and services that better meet consumer needs, we have also challenged ourselves to consider whether our regulatory framework is inhibiting improvements and innovation in the retail market.
Our move to more principles-based regulation should assist firms in responding to market opportunities more flexibly and efficiently, removing barriers and costs created by detailed, complex requirements. From November this year, our Conduct of Business rules will be reduced by half. Our focus will be firmly on principles and high-level rules rather than product-specific and detailed rules - indeed many prescriptive, product-focused rules are being jettisoned. We will be much more explicitly focused on the outcomes that matter most to consumers and we want firms to focus their attention on this as well.
Although we cannot claim exclusive credit for it, the UCITS 3 regime, now fully implemented in the UK, has opened up the range of strategies that UCITS managers can offer within the regulated fund area. We have seen some innovation in the market already, with several 130/30 funds and other variations on hedge-fund-like long/short strategies. But in general, the response seems to have been surprisingly muted. That is disappointing and leads us to wonder about the degree to which fund managers have thought through consumer needs in designing new ranges of funds. Are you clear in your own minds about who the appropriate target audiences for them are? Have you been clear in articulating this to your distributors? Have you gone the extra mile to ensure that distributors understand what products can and cannot do so that they are better sellers on your behalf?
Or is the constraint here the need to build appropriate systems and expertise before you are able to exploit these opportunities? We do expect managers to have appropriate risk management systems in place, particularly when they are using innovative investment strategies, or investing in more unusual or exotic assets, any number of which might be difficult to value. The current market turmoil emphasises the need for strong risk management systems and robust valuation processes and procedures for firms that are holding complex and illiquid assets. While enhanced money market funds and other adventurous structures have not been features of the UK retail funds market, there are no doubt lessons to be learned about the quality of systems and personnel needed to operate competently the wider range of retail funds now coming on stream.
I also observe here that we are aware of some inconsistencies among European regulators in their approach to and oversight of the derivatives risk management systems that are required to be in place for UCITS 3 funds that are investing in derivatives. We have added this issue to the agenda of the CESR Investment Management Expert Group and hope that we will be able to make progress on reaching a common understanding of the standards required. We are grateful in particular to the IMA for the excellent work it has done in this area and would commend its guidance to you.
In addition to the changes now beginning to come through for UCITS, we also expect to publish at the end of the year our feedback and Policy Statement on the changes proposed to the regime for funds of alternative funds. Publication is contingent on the solutions to the tax issues involved in such funds The ability of managers to set up authorised funds of alternative investment funds may well lead to the sort of products for the retail market that so many of you have designed for the benefit of the corporate and institutional market place.
Communications with Consumers
The appeal of a wider range of investment funds to the retail consumer raises significant challenges for fund managers in explaining the performance characteristics and risks of investments. We think it is important to distinguish between explaining how complex products work at a structural level and explaining how they are intended to behave and the range of performance risks that attach to them. There is an obvious difference between the two, the most important aspect of which is that the latter focuses on explaining outcomes to consumers. That explanation requires the fund manager to have carried out robust analysis of the performance of the particular product, and the range of outcomes that might reasonably be expected. The crucial point is to try to ensure that the product outcome matches the outcome that the consumer is expecting. It is also essential to explain the range of possible outcomes so as to try to match, as closely as possible, the range of outcomes that is consistent with the consumer’s risk appetite. If the expectation gap is too wide, the investment is likely to end in tears even if market events are relatively benign.
In more volatile markets, and for investments which are sensitive to particular market dynamics, the potential for a mismatch between investment outcomes and a consumer’s desired outcome is even greater. We would expect complex products to be extensively stress-tested by the fund manager and the products’ performance characteristics and sensitivities explained to the distributor in a way that the distributor is capable of understanding and using appropriately in the sales process. Materials prepared by the fund manager for the end consumer must similarly be fair, clear and not misleading.
A prudent fund manager will also need to keep an eye on the continuing performance of its product range, to assess whether its analysis of the likely performance profile is correct. It may be that events will find a weakness in the analysis or modelling that was done, or an unexpected sensitivity to particular market conditions. In such circumstances, the fund manager ought to consider how to communicate that information to its distributors or directly to its underlying customers, depending upon the relationships that exist.
In financial services, the adviser plays a very important role in matching the consumer risk appetite and desired outcome to the risk profile and outcome range of various products. We are not saying that the product provider assumes the responsibility of suitable advice from the adviser, or should be expected to assess the position of and interact directly with consumers if that is not its business model. Instead we focus on a higher level of assessment by the product provider to assure itself that the consumer audience that is being reached is within acceptable ranges of tolerance of the target market for the product.
We accept of course that an individual's understanding of the range of possible investment outcomes cannot always be secured by the provision of clear information. Hence the essential role of advice in the retail investments market. The Retail Distribution Review suggests an additional solution to the need for more sophisticated analysis of consumer needs, and by extension, the analysis and assessment of risks presented by a wider range of products. There appears to be a broad base of support for the Review's suggestion that we should significantly improve the quality of advice in the retail market. In particular, we should aim to raise standards in the direction of advisors being able to offer a full range of financial planning and specialist advice services. The basis for this improvement would be the introduction of higher professional standards, reinforced through higher qualification requirements, linked to a move in adviser remuneration away from commission.
There are many advisers who will be uncomfortable in coping with the risk and performance characteristics of a wider range of complex investment vehicles. However, we would resist the assumption that complex products are not suitable for consumers while "straightforward" ones are. The Retail Distribution Review may also point us in the direction of agreeing a range of simplicity criteria against which to assess products that might be eligible for the mooted Primary Advice regime. In this context, we have talked about simplicity in terms of simplicity of outcomes for consumers, such that the future cash flows or risks posed by such products are simple to understand. We acknowledge that that this does not mean that the products themselves have to be simple.
Conclusion
In conclusion, it seems to me that the opportunities and challenges for the fund management industry in the retail market are clear. Can you harness the innovation and creativity for which you are so well known to bring to the market products and services that genuinely meet the needs of retail consumers? Can you build on the new technologies that are coming onstream to deliver better value products and services to your retail customer base? Can you communicate to them clearly and comprehensibly the range of outcomes that they should expect and try to avoid mismatches between the performance characteristics of products and the risk appetites of your customers?
The Retail Distribution Review calls upon all the key participants in the investment market – firms, consumers and regulators – to take up the challenge of making a real difference in the outcomes that this market delivers. I am sure that the fund management industry will play its part in achieving those outcomes, thereby truly treating its customers fairly.
Thank you for your attention. I hope you have an enjoyable and stimulating day.
