First published May 2010
It is nearly 40 years since Charley Ellis first categorised investment management as a “loser’s game”. Many institutional investors have taken on board that counter-intuitive message – but how many financial advisers have also absorbed the fact that a proposition that explicitly or implicitly promises clients they can pick funds that 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 January 1 2013 is a potentially game-changing event. 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 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 – surely a 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 IFA 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 (I own a number myself). 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.
Over the five years to end 2009, according to Standard & Poor’s definitive semi-annual survey, more than 60 per cent of actively managed equity funds and 70 per cent 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 fail to obtain even the performance of the average under- performing fund, in the UK case falling short by 2 percentage points a year.
There are two fundamental problems with the current system. One is the obvious one that advisers who are solely dependent on commissions are inevitably compromised by that fact, whether or not their clients in their ignorance prefer it that way.
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 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’s view is that advisers who understand the “loser’s game” and build their advice around that belief cannot 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. In an ideal world, the best 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.