Now, at the end of the second year of Assessment of Value for UK mutual funds, we can expect to see more comment on its strengths and weaknesses. Some of the professional and trade bodies and press that decided last year was too soon for an appraisal may now enter the fray. 
The main challenge is to separate out what Assessment of Value actually adds to value for investors in the marketplace and whether it has improved competition.
The challenge in reviewing the results of Assessment of Value is to separate it out from a wide range of existing regulation and practice. There are already obligations on trustees, authorised corporate directors and others with key responsibilities in service delivery. Managers themselves have product governance, Treating Customers Fairly, conflicts of interest, a Senior Managers and Certification Regime and MiFID trading cost analysis.
Investors and their advisers already have to pour through a range of information from fund reports to key investor documents, analysis services, and ratings provided by the industry. No clear gap was identified in the information available to investors. A document that does not serve a need or gap is unlikely to be factored in with the additional work and cost that brings. It would be unusual for an additional cost and regulatory requirement to actually increase competition, rather than marginalise some players and discourage new entrants.
Of course, scale alone can lower costs to investors, but that may not improve service. It certainly makes regulation easier, except in a crisis when financial businesses can be too big to fail. The costs on society of greater scale and industry concentration are indeed a hidden burden. Most importantly, we know that active investment management tends not to increase returns with scale. Over time, returns tend to dwarf costs.
Regulated public markets have significantly underperformed many private markets in recent years. Yet, fair value is not a concept that is mandated within the Assessment of Value process. It is as if there is a race to the bottom; checking service is comparable, but then focusing largely on a period of historic returns that may not be a guide to the future and on costs which are viewed against the industry’s moving goalposts.
Looking at one part of the wealth management and investment chain in isolation risks missing unmonitored and sometimes unregulated cost elsewhere. This matters, as we are increasingly seeing industry mergers of wealth and fund management that bring vertical integration. There is also some evidence that switching costs are high. Closing or merging funds may have unintended consequences for investors and switching between funds should not be taken as a measure of success for either Assessment of Value or the industry as a whole. Why is this degree of churn not measured and factored into the regulatory framework?
Only investors know their own time horizon and tolerance for risk and volatility – these are not always the same thing. That means they may be using a fund in different ways than other investors, in combination with other assets to deliver a different risk reward profile. Assessment of Value assesses funds but each fund serves a heterogeneous range of investors.
Should active and passive funds be combined in the same comparison? Certainly, passive funds tend to have lower costs, but arguably do not provide the same role. Active managers are better placed to contribute to responsible corporate behaviour, sustainability, price formation in the stock market and trading liquidity, and have key roles in signalling value and bringing non-financial factors into price formation. Certainly passives can vote and may have stewardship policies, but in general they cannot sell the stocks that constitute the benchmark they track. And the price at which they do trade when money flows in or out of an index fund, or index constituents change, is set by the analysis and research of active investors.
It seems strange that at a time when there is more public interest in responsible investing and stewardship of businesses - recognising their broad responsibilities to society and a range of stakeholders - for Assessment of Value to ignore this. Responsible investing is not costless. Integrating it with financial analysis in a holistic approach to investing - with long time horizons and actively engaging with corporate issuers and their boards - costs money to do well. It is anomalous that it gets no attention in Assessment of Value.
It would be surprising if regulation created competition. Insofar as this might drive scale and churn, it may have some unfortunate unintended consequences. In last year’s reports some funds in the industry were criticised because of cost arising from small scale. Yet many of those smaller funds focused on smaller companies or less liquid opportunities. As they are able to concentrate portfolios, with more active share and alpha, many did in fact deliver some of the strongest performances for investors in 2020 and early 2021. Should Assessment of Value give so much attention for the potential for scale to cut costs if that scale also comes with the risk of diminishing investor returns?
These challenges point to the core problem: lack of remedy. Performance variations between funds tend to be much larger than cost differences and past performance within an individual fund is usually not reliable – as the risk disclosures warn. Reducing charges or closing funds sounds like effective remedial action, but may not be the change investors really want. Investors can end up bearing fund merger costs or otherwise adversely impacted by closures. There is a risk that money can be out the market for a period or that an unhelpful tax event is created.
Regulation may no more be able to create consistent performance than it can foster competition. Increased competition often stems from pricing flexibility and disruptive models. Prescription can stifle innovation and longer-term competitive forces. We need to think about the consequences of what may is undoubtedly well-intentioned legislation.
Colin McLean is founder and director of SVM Asset Management. The views expressed above are his own and should not be taken as investment advice.