Leading by example

David examines how the investment company model of independent boards could address many of the issues raised in the FCA’s Asset Management Market Study Final Report.

The investment company sector has largely escaped the fall-out from the latest damning Financial Conduct Authority report into the asset management sector, but there is good reason for it to come under scrutiny. It’s not so much that the sector needs to respond to the regulator’s findings – though of course it does – but more because investment companies in many ways offer the sort of model that the FCA is aiming for.

After all, so much of what has angered the regulator, from high charges to poor performance and from complexity to lack of transparency, really comes down to the governance issue. At the heart of this controversy lies a simple question: for whose benefit is a fund really run? Does the fund exist to deliver the best possible returns to investors, or to maximise fees and profit margins for the asset manager?

The FCA’s conclusion is clear – far too often, it’s the asset manager’s interests that are to the fore, rather than investors’ best interests. The regulator points to the high margins the asset management sector enjoys, which it suggests are closely linked to the high and opaque charges commonly found even on poorly performing funds.

The question that begets is how best to keep asset managers honest. One option is a top-down and heavy-handed approach from the FCA itself, in which it polices managers much more closely and attempts to micro-manage the problem. But that’s an ineffective solution – it penalises asset managers serving their investors well by tying them up in red tape, and is in any case an approach condemned to forever playing catch-up, tackling each new issue after it has emerged.

The better way forward is hinted at in the FCA’s recommendation that asset managers appoint independent directors to their boards – effectively, these individuals would provide a counter-balance to the manager’s shareholders or owners, with a responsibility to ensure that funds are run in the interests of their investors. They would hold the asset manager to account upfront, rather than investors having to wait for regulatory intervention.

If that sounds familiar, it is of course the governance model that the investment company sector operates. Investment company boards have a fiduciary duty to their shareholders – the funds’ investors – by which they are legally bound. This is a model that completely changes the dynamic of the fund – it becomes a vehicle that appoints an asset manager to serve investors, rather than the other way around.

This is not to suggest investment companies are perfect, or that their boards always get every decision right. Closed-ended funds can – and do – generate disappointing returns. Their fees have traditionally been lower, but the fact so many investment companies have been reducing and restructuring charges over the past two or three years suggests there is room for improvement in the sector.

Nevertheless, where investment company boards do their job properly, the big problems that the FCA identifies as dogging the asset management sector should at least be confronted. And in recent times that’s exactly what we’ve seen, with boards demanding lower charges and better performance – and being brave enough to change asset managers where such improvements have not been forthcoming.

It’s a model that works well, shifting the playing field in favour of investors. If the regulator can find a way to implement this sort of governance structure across the whole of the asset management industry, it’s likely to be a much more effective response than simply setting a bunch of new rules.