One year ago, the UK financial regulator raised an uncomfortable question for Britain’s fund management industry: are investment companies too profitable?
The question was posed when the Financial Conduct Authority outlined the scope of a sweeping investigation — the first of its kind — into whether competition in the asset management sector is working effectively.
Twelve months on, the preliminary findings of the watchdog’s investigation, published last week, make for troubling reading for the chief executives of the UK’s largest fund companies.
“Everyone should be concerned,” says one analyst, speaking on condition of anonymity. “We know this report is not positive [for the sector], but we don’t know how negative it will be.”
The FCA’s 200-page report painted a damning picture of the industry and the value it delivers for investors. The majority of active managers underperform their indices after fees, the regulator found.
It added that institutional investors get better fees and performance than individuals, who typically struggle to understand complex charging structures.
More worryingly for the industry, the regulator was explicitly critical of the consistently high profits booked across the industry.
The concern is that asset management companies will now face considerable pressure to reduce fees and increase transparency around their charging structures, which will have a harmful impact on profits.
“These proposals will create significant top-line pressure for the asset management industry,” says Christian Edelmann, head of the asset management practice at Oliver Wyman, the consultancy.
“Profit margins will become more skewed; the relative winners will be those who convincingly articulate how they add value for money and manage to structurally reduce their cost base,” he said.
The FCA found that asset management companies have “consistently earned substantial profits” over the past six years, with an average profit margin, a measure how much of every pound of sales a company actually keeps in earnings, of 36 per cent.
These margins are higher if the profit-sharing element of staff remuneration — essentially bonus payments — are included in the profitability calculations.
Gina Miller, co-founder of SCM Private, the investment boutique, and a longstanding campaigner for greater transparency around fees, says: “The margins are phenomenal. If you looked at equivalent-size pharmaceutical companies, their profit margin would be somewhere between 15 and 20 per cent. Most fund companies’ [margins] are closer to 35 or 40 per cent, so [they are generating] twice as much profit.
“The idea that [asset management] is too difficult to understand is something that the industry has exploited.”
The UK watchdog found that operating margins in asset management are high when compared with other sectors. The average margins of companies in the FTSE All-Share, the index of UK companies, are 16 per cent.
Only one other sector, property investments, records higher profit margins on average, according to the FCA.
The regulator’s initial conclusions, which were based on feedback from 37 fund companies, 13 investment consultancies and eight platform providers, as well as discussions with numerous investment experts, have caused considerable anxiety across the industry.
An asset management analyst, speaking in defence of the industry and on condition of anonymity, says: “Last year it seemed the FCA had already concluded that asset managers were too profitable. Then they used a very small sample size to confirm what they were [already] thinking.
“[The regulator never recognised] that maybe asset managers are profitable because markets have been buoyant, flows have been positive and competition has been driven out of the industry due to regulation.”
Anne Richards, chief executive of M&G, one of the UK’s largest asset management companies, adds: “We have the same type of margin structure as you would with any other [industry that has] high people content [and] low capital intensity. We are not unique in that sense.
“If you look at other industries that are people intensive, our margins don’t look particularly out of line. So we need to be a bit careful around simplistically looking at margin. We need to go back to basic economics.”
The regulator did, however, compare asset management margins with those found in industries with similar business structures. Margins in sectors that also have high staff numbers and low physical capital are between 4 per cent and 33 per cent on average, according to the watchdog.
“All the data provided suggest that profitability is high relative to market benchmarks. The results of our analysis are consistent with competition not working as effectively as it could,” the regulator said.
The expectation is that the FCA’s proposed package of remedies, which includes greater transparency, comparability of fees and the introduction of independent governance boards for funds, could temper asset management profits.
This is particularly the case for fund companies with large retail client bases, such as Jupiter and Schroders, the UK-listed groups that both recorded operating margins of 51 per cent last year.
Retail investors account for 75 per cent of Jupiter’s client base and 32 per cent of Schroders’.
The regulator found profit margins were far higher for retail products than for institutional equivalents. Funds sold to retail clients typically underperform their benchmark after fees, whereas funds sold to institutional investors such as pension funds slightly outperform.
The regulator’s intervention is an important step towards addressing this imbalance between how retail and institutional investors are treated, even if this comes at the expense of fund companies’ incomes, according to several senior asset management professionals.
Saker Nusseibeh, chief executive of Hermes Investment Management, told FTfm in September: “There is a larger profit margin in retail [fund management]. That has to be scaled down. The FCA is also trying to reduce the fees payable on retail funds, [because retail fees] are much higher than institutional. We welcome that too.
“We think all fees should be the same. It costs the same to run institutional money as it does to run retail money.”
Amin Rajan, chief executive of Create Research, the asset management consultancy, adds: “It has been blindingly obvious for years that lack of serious competition has delivered high fees and profits at the expense of the end investor.
“It is good to know that the regulator is finally serious about ensuring that asset managers deliver value for money. Previous regulatory reviews delivered pious hopes and not much else. The necessary enforcement was not there. Let us hope this time is different.”
Additional reporting by Aliya Ram