Is this the future shape of investment portfolios?

By Charles Owen, Founder and Director at CoInvestor

On Friday 18 November, the FCA published its interim report on the Asset Management market. All 206 pages of it. This report has been a long time in the making and points to some fundamental and challenging issues for the industry to address. It is undeniable that this will set the scene for potential far reaching changes to how asset management firms work with the investors whose money they invest, specifically the retail investors who account for more than £1 trillion of investment funds. 

Much of the focus of the report went to the heart of the ongoing argument between active or passively managed equity funds. The FCA didn’t hold back its punches;

• Many active funds closely track their benchmark and therefore offer similar exposure as passive funds but at considerably higher costs. 
• Once costs are taken into account then evidence suggest that actively managed funds do not outperform their benchmark. More concerning still is that funds available to retail investors tend to underperform their benchmark after costs whilst products available to pension schemes and other institutional investors achieve returns that are not significantly above the benchmark. 
• £20,000 invested in a passive fund over 20 years might earn c. 44% more than an investment in an actively managed fund assuming the same fund returns profile
• Mainstream actively managed fund charges have remained broadly the same over the last 10 years whilst charges for passive finds have fallen over the last five years. The annual average disclosed fee for actively managed funds is 0.90% of AUM, six times greater than the average 0.15% for passive funds. Transaction costs are also higher for actively managed funds 
• There is considerable price clustering for actively managed equity funds, particularly once AUM is greater than £100m. As fund sizes increase price does not fall meaning that economies of scale are captured by the fund manager rather than passed back to investors in the fund.
• Weak price competition in a number of areas of the asset management industry due to lack of fee pressure has a material impact on investment returns 
• The investor bears virtually all the risk

The FCA is not standing alone in starting to take a position on the asset management sector and the European commission is expected to recommend that EU regulators also investigate asset management performance and fees. It is highly likely therefore that the asset management industry will need to take action to address many of the issues highlighted above or will be forced to do so by specific FCA regulations.

As a result, it is not unreasonable to suggest that retail investors will respond to these changes in a highly rationale way as information becomes more readily available to them and will substantially re-balance their portfolios so that the majority of their equity exposure is via passive funds and ETFs. This journey has already started and the use of ‘packaged’ technology solutions such as robo-advice is driving take up. As retail investors become increasingly comfortable with these digital access routes, and more aware of the costs and relative underperformance of actively managed funds, expect the current stream to turn into a torrent.

Looking forward then my view is that direct retail and advised investors will end up with investment portfolios made up primarily of passive low cost equity/bond funds and up to 40% in select active funds and alternative investments. These will have very clearly defined investment criteria and return objectives for alpha. This is backed by an industry study by Oliver Wyman and Deutsche Bank which found that over the past decade, alternatives generated c8% alpha p.a. against listed strategies which, net of fees, returned almost zero.

We can expect this alternative allocation to include focused requirement for capital growth (both listed and unlisted), yield and tax efficiency. Asset management firms will either become passive behemoths or shrink their AUM’s to become highly focused specialists delivering against very specific investor requirements.

VCT and EIS managers able to deliver a track record of capital growth in a tax efficient manner have a rosy future.