I posed a question on this blog a couple of weeks ago: Why do so many advisers recommend active funds? I didn’t express my own view; I’ll come to that later. What I wanted was to generate debate on an issue I consider to be of huge importance and which, for those who make it to retirement, will eventually impact on all of us.
My question was prompted by the Financial Conduct Authority’s interim report on its study into competition in the UK asset management industry. The FCA found that “actively managed investments do not outperform their benchmark after costs”; the true cost of using them is hidden from investors; past performance data is often misleading; and, after costs, active funds deliver significantly lower returns than passively managed alternatives.
Robust, independent and damning evidence
The findings were summarised by Michael Johnson from the Centre for Policy Studies as follows:
“(The FCA’s) robust, independent and damning evidence skewers any justification that active fund management of listed assets is worth the candle."
The fund industry’s response to the report has been predictably prickly. The boss of one City fund house described the FCA as “definitely pro-passive”. In truth, however, the regulator was merely confirming (in my view far too late) the overwhelming conclusions of more than 30 years of peer-reviewed academic research on the value that active management adds to — or, in the vast majority of cases, the value it extracts from — the investment process.
Why has it taken so long?
As Dr David Blake, Professor of Pension Economics at Cass Business School in London, put it to me the other day: “Why has it taken the FCA quite so long?”
Anyway, back to my original question: Why do so many advisers still prefer active funds, especially given that, in the UK at least, advisers are now banned from receiving explicit commissions from fund providers?
When I recently asked the same question of Gina Miller, a fellow campaigner for transparency in asset management, she said this:
“(Advisers) are conflicted. (They’re given) soft commissions. They’re invited to lavish sporting events, flown around the world to conferences. And because the big fund houses spend so much on advertising, it’s so much easier for an adviser to put a glossy brochure across someone’s desk rather than doing their job, which is finding the best product for that investor.”
Paul Armson, the Founder of Inspiring Advisers, took a similar view:
“The industry is so powerful and the advertising is so good that it’s very difficult for advisers to change their bad habits. They’ve been doing it for so many years that it’s difficult to get them to think about what they should be doing.”
No wonder, when I posted those two interviews on social media, that a heated debate ensued. Suffice it to say, most contributors didn’t take kindly to either Gina’s comments or to Paul’s; both were accused of exaggerating, talking down the advice profession and tarring all advisers with the same brush.
Nobody likes to see their profession criticised
I can absolutely see where the advisers who took umbrage are coming from. Nobody likes to see their profession criticised and we’re understandably sensitive to any suggestion that we’re all as bad as each other; believe me, as journalist, I understand that feeling as well as anyone.
That said, advisers who are genuinely active on Twitter are a small minority and, almost by definition, they tend to be more thoughtful, dedicated and professional than the average adviser. There are about 15,000 advisory firms in the UK, and in the five years that I’ve been focused on the investing industry, I have been truly shocked, time and again, by the lack of basic knowledge and understanding that some advisers seem to have.
Again, the FCA report provided evidence of this. For example, one of the key findings of academic research on fund returns is that past performance is no guide to future performance, and in fact can be very misleading. Yet the FCA found that “when asked which factors were influential in the (adviser’s) choice of funds, 44% of respondents stated past performance was an influential factor”. It also found that awareness among advisers of charges — which research has repeatedly shown are the most reliable predictor of future returns — was low.
I dare say, most of the advisers who criticised Gina Miller probably have little or no personal experience of the sorts of inducements she was referring to. But again, the evidence that such inducements are being offered — especially to key decision-makers in large advisory firms — is clear to see in a separate FCA report issued in April this year.
I also agree with Paul Armson that industry advertising plays a part in some advisers’ preference for active funds, and that there are some advisers out there who continue to advocate active management because that is what they’ve always done.
Another explanation I’ve heard is that advisers are in denial, that they’ve convinced themselves that active funds are the best option and they won’t allow anyone to tell them otherwise. For some advisers there may be an element of truth in that.
Have they read the evidence or not?
For me, though, it all boils down to one thing: Have advisers read the evidence on active fund management or haven’t they? The research is so compelling that the only two explanations I can think of for advisers failing to act on it are the following:
1. They haven’t read the evidence.
2. They have read it, but, for whatever reason, they’ve chosen to ignore it.
Unfortunately, and very regrettably, I suspect that a large number of advisers have not read the evidence on active management. That these people are advising clients at all is a cause of great concern.
I do however believe there are more advisers who fall into the second category; in other words, they’ve chosen to ignore the evidence. That, of course, is just as inexcusable, if not even more so. But it’s also understandable. Let me explain.
Ultimately, the investment advice you receive from someone depends more than anything else on that person’s business model. For the last 50 years or so, the business model of the average adviser has been built on beating the market; in other words, advisers have attracted and retained clients primarily by convincing them that they know which sectors and regions you need to be invested in, and which fund managers are most likely to outperform the market. Essentially that “expertise” is what they’ve been selling and, financially speaking, thanks to commissions, it’s a model that has served advisers (if not their clients) very well.
Of course, in the 1960s or 70s, that was a more credible value proposition. Although, after costs, the vast majority of managers underperformed, a reasonable number of them did beat the market, at least for short periods. Also, in those days, passive funds were far more expensive that they were today; often the fees, scandalously, were on a par with actively managed funds.
Today, though, when passive funds are so much cheaper, there is no longer any excuse for continuing to ignore them. By including even an element of active management in a client’s portfolio, an adviser is more or less consigning that client to a smaller pension pot when they come to retire. In my view there are many advisers, particularly those in their 50s and early 60s, who have come to realise this, but who simply aren’t prepared to invest the time, effort and resources involved in completely changing their business model. They’re also worried that they won’t be able to charge as much for recommending index funds, and that many of their clients will choose to dispense with their services altogether.
For me, it’s this reluctance to change the traditional advice model which causes so many firms to carry on recommending investment products that it’s patently not in clients’ best interests to buy.
Advice is changing
Make no mistake, the advice profession will change over the next 20 years. Indeed, the process is already well under way in the United States, where most of the fastest-growing advisory firms use mainly passively managed funds.
Financial advice from now on won’t be about predicting future market movements or pretending to know who the star fund managers of the future are. It’ll be about educating clients, and telling them not what they want to hear but what they need to hear; about helping them to lead the lives they want to lead; and about using their wealth for good — both for their own families and for the wider world.
Firms can rebuild their businesses accordingly, or continue to bury their heads in the sand. The choice, advisers, is yours.