It is nearly 40 years since Charley Ellis first categorised investment management as a “loser’s game”. Many institutional investors have now taken on board that counter-intuitive message - but how many financial advisers have also absorbed the fact that an advisory proposition that explicitly or implicitly promises clients they can pick funds which consistently beat the markets after costs is a near-certain losing proposition in the long run?
The FSA’s Retail Distribution Review has perforce brought home to many IFAs the need to recalibrate their business models. The plan to phase out the practice of advisers taking commission from retail products on which they give advice from 1 January 2013 is a potentially game-changing event, although a number of details still remain to be finalised. As it will only apply to new advised business from that date, the effects will not be instantaneous. Trail commissions on legacy and execution-only business will continue to support IFA livelihoods for a while.
In that sense the RDR is not such a potentially dramatic change as, say, Big Bang. Personally, I find such gradualism rather too British for my taste. Like any worthwhile reforms, an assault on commission-driven advice, messy and liable to unintended consequences though it will undoubtedly be, should have happened long before now. It is a fact of life that well-funded industry lobbyists will always argue for delay and compromise, even when faced with the most common sense proposals. For evidence, just look at the forces of reaction queuing up to resist the idea of separating retail and investment banking once more, where there has surely rarely been a more clear-cut case for reform.
Sometimes important issues really are simple, and the inherent faults in commission-based financial advice constitute one such issue. To my mind the issue is not so much whether adjusting the commission system will lead to changes in the standard industry business model, as it clearly will, and clearly should, but whether it will in practice also lead to a change in advisers’ fundamental belief systems – the point being that running a commission-based advisory business effectively forces you to nail your colours to investment solutions that are often sub-optimal, and in defiance of all known experience.
There is a reason after all why index funds, ETFs and investment trusts, which generally pay no commission, still find little favour in IFA client portfolios. Active fund management is not of itself an indefensible proposition. I am certainly persuaded that there are some active fund managers whose funds are worth owning (and I own a number myself). Multi-managers also have a role in matching funds to client objectives.
The question however is what role those funds should play in a client’s overall portfolio. The evidence that clients’ core exposure to the main asset classes is best obtained through low cost passive instruments is simply too overwhelming to be ignored. An adviser who is genuinely acting out of a sense of fiduciary duty to his client can no longer reasonably fail to acknowledge that fact.
Over the five years to end 2009, according to Standard & Poor’s definitive semi-annual survey, more than 60% of actively managed and 70% of fixed income funds in the US failed to beat their benchmark indices. A recent academic study of the UK fund market confirmed the well-known US finding that most fund investors fall short of the performance of the average fund, in the UK case by some 2% per annum.
There are two fundamental problems with the current system. One is the obvious one that advisers who are solely dependent on commissions are inevitably to some extent compromised by that fact, whether or not their clients in their ignorance prefer it that way. In a fee-based reward system, advisers can of course choose to rebate part or all of any commissions they receive to their clients, and some do, although this practice could, oddly, also be phased out in the UK by the RDR.
The second more fundamental problem is that fiduciary duty in the accepted legal sense is not a concept by which financial advisers appear to be legally constrained. (Suitability of products and other FSA criteria are weaker tests). Clients are often ignorant and the decisions that they should be most concerned about, which principally means asset allocation, are unfortunately the ones they understand least and are paradoxically the ones most poorly remunerated by the market.
Mr Ellis’ view is that advisers who understand the Loser’s Game and build their advice around that belief can not only go to bed every night with a clear conscience and a sense of professional pride, but are more likely to stay in business for the long term. It seems that Vanguard, of which Mr Ellis is now a director, is making that pitch a key part of its proposition as it attempts to break into the UK retail funds market.
In the United States, it reports, only 12% of firms in wealth management now base their pitch on superior performance. Service is instead the key criterion. By including a bigger chunk of indexing in their client portfolios, many advisers are discovering not only that their clients are doing better as a result, but that the risk of being fired by the client is also diminished.
In an ideal world, good advisers would become wealthy not, as now, merely for giving advice to as many clients as possible, but for giving the right advice – a fundamental difference. Nobody of common sense should fear such an outcome. But there is still a long way to go before that becomes a reality. Whether the RDR does the job remains for now still a hope rather than a certainty.
