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Vertical fund businesses – a broken model?

Vertical fund managers control the entire investment “ecosystem” - from manufacturing fund product through to advising the end investor.  This means the fund manager can be a “one stop shop” providing the (supposedly) perfect client solution, isolated from any alternatives.  It makes great business sense – but does it make sense for investors?

Tuesday, September 1st 2015, 1:30PM 7 Comments

by Pathfinder Asset Management

In this commentary we look at implications of the vertical model.  Does capturing revenue at every step of the value chain mean there is excessive “ticket clipping”?  What about conflicts of interest between the manager and investors?  Can investors end up owning product that is second best?

Vertical integration – it’s on the FMA’s radar

In its annual “Investigations and Enforcement – Key Themes” paper, the FMA highlights “conflicted conduct” as a core risk for markets and investors. 

They rightly identify that conflicts of interest can be deeply embedded in business models. According to the FMA: “Although we do not oppose vertically integrated business structures, robust processes must be used to ensure customers’ interests are protected and put ahead of the profit-making interests of the providers involved.”

Below we identify examples of “conflicted conduct” from vertical businesses models.  Should these concern investors?

Stuffing own-branded product

Henry Ford famously said that buyers of his Model T car can have any colour as long as it’s black.  Many vertically integrated fund managers have taken this thinking a step further with their investment clients – they can have any investment product as long as it is the house brand.

This was the focus of an FMA inquiry which looked into the impact of a vertically integrated business on the appropriateness of advice given to investors (see page 6 of the FMA’s “Investigations and Enforcement – Key Themes” paper).  The FMA found that advisers in a vertical business have a critical role.  This role requires advisers to question the information they are provided,  including questioning information about funds produced and managed internally.

Here is an extreme example (taken from a vertical fund manager’s 2014 business overview).  Unsurprisingly a high percentage (32%) of client investments were in that firm’s managed funds.  What was alarming from a client perspective is the institution’s business plan claiming “within a client best interest framework” they are working to lift client holdings of in-house funds from 32% to 50%.

It is a mystery how head office could claim lifting client exposure to in-house funds from 32% to 50% was “within a client best interest framework”.  The funds had the worst possible combination of high fees and comparatively poor performance.   But from a business perspective here is the magic of the vertical model – regardless of investor interests you can prioritise your own product and even make your own product the sole solution. 

When you go to KFC or McDonalds you will only be sold their own product.  We don’t expect their counters to offer better outside product.  But advising on investments is not selling fast food.  Should advisers be required to use “best of breed” product rather than default automatically to the in-house solution?  (By all means use in-house product if it is the best, but what if the in-house solution is inferior?)

Related party transactions

By offering a full suite of financial services a manager can become conflicted about whether to transact internally or use an external counterparty.  A fund manager that is also a bank can provide currency, deposit and share broking services to the fund.  But should they?

One such institution stated in its 2013 fund accounts “forward foreign exchange contracts are transacted following a competitive tender process with a number of counterparties from which the best transacting forward rates are chosen.”   In 95% of transactions a related party was chosen as the counterparty.  Regardless of whether they provide the best market price 95% of the time, optically this is a very bad look.  There is no evidence investor interests were harmed – yet the perception a conflict exists is damaging to investor confidence.

Excessive ticket clipping

By controlling the entire value chain it becomes tempting to clip the ticket at every step.  It can build a culture that layers fees and lowers transparency.  For example one vertically integrated non-bank fund manager charges its funds “up to 0.50%” on currency transactions.  What?  The base management fee is paid for executing trades – the manager shouldn’t charge an additional fee for arranging fx transactions with the bank.

Is there a better model?

A simple model is better - specialist fund managers produce products and independent advisers select from the market what is best for clients.  Product manufacture and distribution are separated.  Conflicts and related party transactions are significantly reduced.
Given the landscape of NZ financial markets this suggestion will be regarded as extreme and unrealistic.   This is, however, exactly what Westpac achieved in relation to Trans-Tasman equities by seeding the Salt Funds Management business.

If separation is too extreme then the next best approach is for the advisers of vertical businesses to select the best product in the market for clients.  This might mean selecting internal product, but it might not.   While the FMA’s “Investigations and Enforcement” paper does not oppose vertically integrated business structures, they urge care around conflicted conduct and the need for providers to “always put their customers’ interests first.”  Isn’t selecting the best product available in the market actually what acting in client interests means?

John Berry, Director
Pathfinder Asset Management Limited

Seek advice:  Pathfinder is a fund manager and does not give financial advice.  Seek professional investment and tax advice before making investment decisions.

Tags: Pathfinder Asset Management

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Comments from our readers

On 1 September 2015 at 5:51 pm cbm said:
Your final comment is very relevant - indeed, clients generally think their Adviser is recommending what he or she believes to be 'best'. While this might be a subjective judgement on the evaluation of each product, I once asked the question of an FMA 'monitor' and was told that recommendations only needed to be 'suitable' and not necessarily 'best'.
Besides, if a large number of Advisers recommended what they thought was best as opposed to what their contractual counterparty 'suggested' they would be in breach of corporate obligations. This is a very BIG issue in determining exactly what 'putting the client interest first' actually means! It is part of the determinant between 'salesperson' and 'Adviser'.
On 2 September 2015 at 8:15 am MPT Heretic said:
A vertically integrated model might be worse for investors...but it might be a much better option. Like most things in life it depends. Having internal products does not necessarily mean underlying assets are managed internally..often they are merely a cost effective wrapper for best of breed. Having independent advisers determine what the best options are is all very well if they have the skill set, time, resources and economies of scale. Often they dont and a well run vertically integrated model can offer all those things.

As for client interests being put ahead of the providers profit making, surely to be successful and sustainable all parties need to share in the outcome
On 2 September 2015 at 9:27 am Brent Sheather said:
Nice article. Don’t expect anyone in the Government or the FMA to upset historic or prospective employers by properly addressing the problems of vertical integration. Instead they will advocate, as usual, disclosure which has been shown to be totally ineffective in protecting consumers. Putting client’s interests first is definitely not a priority but talk is cheap.

Brent Sheather
On 2 September 2015 at 2:32 pm traveller said:
The problem for advisers is: do I get fired if I don't use enough of the boss's product.And if they do follow the party line, is this in conflict with the code of ethics?
On 2 September 2015 at 5:07 pm Pragmatic said:
My bet is that neither the consumers, industry nor regulator will disband vertical integration models.... it'll be the large financial institutions themselves.

The combination of relatively poor IRR from forays into wealth management, high profile rogues, the ongoing pursuit for heightened shareholder profits, and pending Basel iv requirements placing further restrictions against tier 1 capital ratios will all contribute towards the unbundling of the existing models. Cast your minds back to the financial institution ‘land grab’ of sharebrokers… and then the realisation that perhaps that wasn’t the business for them
On 3 September 2015 at 9:44 am R1 said:
@MPT Heretic: "Having independent advisers determine what the best options are is all very well if they have the skill set, time, resources and economies of scale. Often they dont and a well run vertically integrated model can offer all those things."

What a ridiculous comment and typical of the big corporates arguing an ideology that suits them rather than their clients. Even IF they (vertically integrated firms) did have the skills, etc. their fees are obscene for their scale, their heavy bias toward their own products is not because they are 'best of breed' and clearly not in the client's best interests. It is simple and efficient for the business and the advisor often gets kickbacks (read their disclosure docos) or career limited if not doing the right thing by the employer (naturally enough). It is called systemic corruption when you overlay this with regulators that do not enforce the law (not to mention being even and fair). Brent Sheather's article in The Herald this week explained how this is not unique to NZ but some countries are starting to tackle it. Wouldn't it be nice if NZ decided to be a leader on this; I will not be holding my breath.
On 3 September 2015 at 5:01 pm MPT Heretic said:
Why is it ridiculous R1? John is presenting an argument here which supports his business model. Nothing wrong with that and I certainly know of large businesses which have all the issues he has addressed. All I was doing was pointing out that that is not all of them. Some do a great job of using scale and resources to deliver quality outcomes. Just as some independent advisers using John's proposed 'simple model' have done a rubbish job, and some have done well for their clients.

With so few advisers in the industry full-stop perhaps our time would be better spent focusing on growing the pie for all.

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