Con Keating considers the impact of increasing demands for disclosure and transparency.
Some 18 months ago Andy Agathangelou’s early investigations into problems of disclosure and transparency in the financial services industry led to the formation of a group known as the Transparency Taskforce (TTF), which has rapidly grown in numbers and influence. While much of the initial attention has been on costs and fees in pension fund management, it has broader ambition, encompassing mandate terms and conditions, performance evaluation and decision-making, and international comparability.Judging from the number of initiatives now under way, the TTF has sparked a veritable bushfire. The FCA, where Daniel Godfrey, the ousted CEO of the Investment Association, has been retained as a consultant, is due to report in September; the Association of Member Nominated Trustees has adopted cost and fee disclosure as another of its workstreams; the Investment Association, where much reticence was previously evident, will shortly announce the formation and composition of a taskforce to develop a cost and fee disclosure standard. Perhaps most tellingly, at least four major fund management groups have created internal IT working parties to prepare for the technological challenges of disclosure.The reason that this should now be taking place, when after all the status quo has developed over and existed for a very long time, seems simply to be that costs and fees are now more significant than previously for total achieved performance. For many investors the motivation is clear; disclosure and transparency are associated with lower costs and fees and resultant higher net performance, and there is some supporting evidence for this from the Dutch disclosure experience. ‘Value for money’ is the new mantra, even if, or perhaps because, that is an extremely slippery concept. It is clear that many traditional defences of high fees, such as ‘you get what you pay for’ now have little or no weight. In any case, that particular assertion has always lacked empirical support.While welcoming greater disclosure as a facet of enhanced accountability, some caveats are advisable, if only to hold off the excesses of the more extreme transparency zealots. It is well known that transparency may have a dark side; it need not be harmless, and this is particularly true of mandated (or regulatory) disclosure. Mandated disclosure is attractive to regulators as an easy option; it lowers the pressure on them to write and enact better, and usually more difficult regulation; a version of Gresham’s Law, where bad law drives out the good. Disclosure can also shift the burden of responsibility and liability from the fund manager to the investor.The most worrisome of the downside features is the tendency for disclosure to lead to false confidence and poorer decisions. In fact, increased disclosure can do little to inform rational portfolio manager selection, as has been demonstrated by the work of Alex Adamou at London Mathematical Laboratories. His work shows that the length of track record necessary to distinguish between the skill content of independent funds is measured in decades or centuries. The standard five-year track record, so widely used by investment consultants, requires an excess performance of 16% to be statistically different.The time necessary to distinguish between funds or managers, of course, decreases as the correlation between them increases. In the limit, when then correlation is unity, all of the excess returns of a fund must be due to skill. Adamou shows the correlations needed to rescue the five-year track record meme are very high indeed; a correlation of 1.00 is necessary when the excess performance is 1% p.a., 0.99 is necessary when the excess performance is 2% p.a. and this only falls to 0.9% when the excess performance is 5% p.a.There is a real challenge here. Active fund management is usually considered and measured in terms of its departures from the benchmark, with an implicitly lower correlation, but that lower correlation makes the task of establishing true value added massively more difficult. This, incidentally, casts doubt over many of the central arguments against closet indexation, and those value for money arguments. In addition, it also casts doubt over the value of manager selection services offered by investment consultants, but the really big take-away, to rephrase Adamou, is that a market for fund management services cannot possibly work.There are other important ramifications; to quote Adamou again: “More broadly, this simple computation illustrates how concepts like markets and performance-based pay that can make sense in some contexts are utter nonsense when they are applied elsewhere, especially in systems that contain a large element of randomness.”The one thing which is already clear, and does not need statistical analysis is that this transparency movement will lead to both cost and revenue pressures for fund managers.Con Keating is head of research at BrightonRock Group“‘Value for money’ is the new mantra, even if, or perhaps because, that is an extremely slippery concept.”
Con Keating
