Hidden risks in third-party distribution
Do you know who your investors really are? Not the institutional clients and big sophisticated investors, but the millions of ordinary savers or retail lump sum investors you may have acquired over the years? For fund managers across Europe, reliance on intermediaries not only comes at a cost of margin and the opportunity cost of missing out on granular market data, but it can present significant business and compliance risks.
According to a European Commission study, the share of EU household financial assets placed in investment funds fell from 9% in 2004 to 7% in 2015. In most markets, a few big banks dominate retail distribution. They decide which products customers are directed to and what choice they are offered. When banks’ top priority is to bolster their deposit base or raise capital through bond issues, it is easy to predict where the sales effort will focus.
Particularly in southern Europe, independent fund managers face a further challenge. In Spain, two-thirds of funds are captive in-house funds offered under the distributor’s own brand. Own brands take about half the market in Italy and Germany too.
Concentration of distributor power
Consolidation after the financial crisis, as with Spain’s Bankia or Lloyds Banking Group in the UK, has tended to concentrate distributor power even further. The ECB’s Herfindahl index, which measures the share of assets of the five largest banks in each market, has headed in the wrong direction in most member states since 2014.
Fund selectors have also slimmed the number of funds on offer too, further distancing many fund providers from access to the retail market. Not only do banks, or retail platforms such as Hargreaves Lansdown in the UK, monopolise access to the client, they own their data and the insights that can offer up – and cross-selling potential. Increasingly too, with the advent of open banking and growing use of artificial intelligence, banks and fintech firms are mixing transactional and lifestyle data to maximise their share of each customer’s spending and knowledge of which products they are likely to buy.
But for now at least, there’s little focus placed on another issue accentuated by the dominant role of intermediaries. Not knowing who your customer really is represents a potential reputational and compliance risk. Distributors are responsible for KYC compliance, a critical fiduciary duty over which fund groups have little control, apart from the due diligence they conduct on the intermediaries themselves. But it is the fund groups that will be held to account by their regulators if wrongdoing should come to light.
Managers of retail UCITS funds similarly have little control over whether their funds are truly suitable for the end-investors to which they are sold. As recent fund suspensions resulting from liquidity problems have demonstrated, a fund may be suitable for some retail investors, but not others, and the consequences of managers having to freeze investor redemptions may be catastrophic.
Even when products perform as intended but investors do not like the results, the fund producer is liable to suffer reputational damage, even if they have never actively promoted the product. Those risks are increased by the rise of the online investment platform, where investors are offered a range of products filtered according to fairly basic criteria.
As the case of Woodford Investment Management demonstrates, hundreds of thousands of investors can be easily nudged towards products that may be unsuitable for their needs. The UK’s Financial Conduct Authority has promised to look again at fund supermarkets’ ‘best buy’ lists for their impartiality, and whether the funds they promote truly meet investor needs.
With a review of the MiFID legislation also promised at EU level, it may well be that distributors will revise their fund rosters, further squeezing asset manager pricing and potentially restricting investor choice. As the UK’s Retail Distribution Review demonstrated, restrictions on the remuneration of intermediaries through commission can have a devastating impact on end-investors, by pushing retail investors away from advisers, who must now be paid, toward execution-only platforms when they do not have sufficient expertise to select the right fund, or prompting them to quit the fund market altogether.
The fund industry has three potential solutions to this issue, each with its own drawbacks. The most extreme response is to withdraw products from the retail market altogether. Such decisions may come sooner than the industry expects, if national and European Commission reviews of liquidity requirements tighten rules on assets, such as property, that are naturally less liquid than listed securities.
A second, more palatable response would be to use technology to communicate directly to potential retail clients. But direct sales constitute a relatively small part of overall fund distribution in Europe, and building a brand requires significant marketing resources and time.
The third option may be open only to a handful of fund groups. Buying a distribution platform is an expensive business; the sale of Allfunds Bank in 2017 valued the business at €1.8 billion. And even the one-off purchase of a big cross-border platform may not be enough. The platform industry is consolidating as it seeks scale and cost benefits; Allfunds should complete its merger with Credit Suisse’s InvestLab early in 2020.
Strategically, and at a time when managers are outsourcing non-core functions, buying distribution channels may not appeal, or be feasible, to every asset manager. Europe’s distribution inbalances, and the risks they bring, will not be disappearing any time soon.