That Midas touch can prove elusive

The Financial Conduct Authority says that small private investors are paying a high price for a service that does not result in higher returns. Picture: Getty
The Financial Conduct Authority says that small private investors are paying a high price for a service that does not result in higher returns. Picture: Getty
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The fund management industry is coming under intense – and justifiable – scrutiny, says Gareth Shaw

I’m talking about the fund management industry. When it comes to investing in funds you, broadly speaking, have two options: passive or tracker funds, which, as the name suggests, track markets for a low annual fee; and active funds, where you pay a premium price for an ‘investment expert’ to pick the stocks that will outperform the market.

Active fund managers justify their fees by saying they have the skill to pick tomorrow’s winning investments and secure you better returns. But their gleaming image of superior stock selection has been well and truly shattered by a damning report issued by the Financial Conduct Authority, which spent the last year investigating the industry.

The thrust of the FCA’s concerns was that a significant number of active fund managers are failing to beat the markets and, once you take into account the fees charged, investors are no better off than they would have been in tracker funds.

One of the reasons for this is an investment phenomenon known as “benchmark-hugging” or “closet tracking”. With many fund managers fearful that they’ll get their bets wrong amid particularly volatile markets, they are instead investing almost identically to a particular stock market benchmark. They settle for average returns rather than risking poor performance, but can get away with charging ten times the amount of a normal tracker fund because they’re still selecting funds. Apparently, there’s £109 billion sitting in these benchmark-hugging funds.

So how does it work in practice? If the stock market benchmark is, say, five per cent, some active managers might try and make ten per cent to justify their higher fees. However, chasing higher returns comes with risks, and in reality many managers aren’t taking those risks, instead opting for returns around the same level as the benchmark they’re trying to beat. The upshot for consumers – you’re paying for a service you’re not getting.

What’s more, despite more than 1800 companies offering investments to UK consumers, active funds don’t appear to offer investors much choice on price at all, as they all charge around one per cent a year, no matter if your investments rise or fall in value. The FCA says that small private investors are paying a high price that doesn’t result in higher returns.

The FCA’s report also said that fund managers have been enjoying consistently large profits over the years while their clients – you and I – have suffered disappointing investment performance.

In the next few months, the FCA could implement a number of new rules to get these companies to up their game – by making their costs clearer to consumers, ending hidden charges and imposing a stronger duty on fund managers to ensure they act in the best interests of clients. To me, that final point says it all – an industry that looks after trillions of pounds of our money has to be forced to act in our best interests.

Now I’m not saying investing is bad for your financial health, quite the opposite, in fact. At a time of record low returns on cash, taking a calculated risk over the long term provides far more potential for a bigger pot of savings than leaving your money sitting in a cash account. And, despite appearances, I don’t believe that all active funds, or their managers, are rotten. Some managers really do have that Midas touch to outperform the markets, and for certain styles of investing, such as generating an income, active funds may well be the best option.

The problem is that good active funds that consistently live up to their promises are rare, and it’s extremely difficult to know which ones will do it in the future. With the failures of this mammoth industry now under scrutiny and its reputation suffering an almighty dent, fund managers need to change – perhaps starting with a little less profit for them and a little more for us – or risk being labelled a rip-off forever.

Gareth Shaw is head of Which? Money Online