A wide-ranging report on the UK asset management industry by the Financial Conduct Authority (FCA) cited several failures within the investment consulting industry, including several concerns regarding conflicts of interest.
The manager rating process through which consultants assist pension funds and other institutional investors in manager selection acts as a “barrier to entry, expansion, and innovation,” according to the regulator.
“In some cases asset managers are expected to have a three-year track record in order to be rated, which an be a barrier to entry for new asset managers,” the FCA said. “This feeds into the emphasis on past performance.”
Furthermore, while consultant due diligence on managers reduced operational risk for investors, the FCA found that consultants on average failed to identify outperforming managers.
“When looking at the performance of investment products recommended by investment consultants our analysis shows that, across all product categories taken together, consultant-recommended products do not perform better than non-recommended products,” the report stated.
The regulator did find outperformance across the board, with recommended and non-recommended managers outperforming benchmarks by 80 to 100 basis points annually on average. However, much of this outperformance was eliminated by fees—and the consultant rating process has done little to drive fees down, the FCA said.
“While consultants appear to recognize that fees are important, their emphasis appears to be on making sure that managers’ fees are in line with the market rather than driving fees down,” the report continued. “There is an emphasis on negotiating fees for clients with a larger amount of assets, who may have been able to receive scale discounts from managers anyway.”
Finally, the FCA cited several possible instances of conflicts of interest, including a “strong culture of gifts and hospitality… which could influence the ratings given to managers.”
Consultant fees charged at hourly rates also encourages consultants to recommend complex strategies that require more time spent researching and monitoring, the regulator said, while the increasing trend of consultants offering fiduciary management (outsourced-CIO) services means consultants are incentivized to offer their own products.
“Investors are aware of consultants’ conflicts but that may not be enough to mitigate the risk,” the FCA concluded. “It is hard for investors to assess whether the advice they receive is good… This is exacerbated if trustees fail to challenge information they do not understand, which can be the case with trustees of smaller schemes.”
Read the FCA’s full report here.