Collective Investment Schemes
The Changing Environment
formerly Chairman of the Unit Trust Committee and formerly of Midland Bank plc
(taken from Issue No 1 – July 1996)
Benjamin Disraeli once said ‘Change is inevitable. In a progressive country change is constant.’
Before considering the aptness of those words in relation to collective investment schemes I must make two things clear. The first is that the opinions expressed below are personal ones. The second is that although the phrase ‘collective investment scheme’ can have a wide interpretation I restrict myself to unit trusts and open ended investment companies.
The industry growth record
In trying to shape the future we must understand the past looking at the growth of the unit trust industry over the past sixty years one sees that the rate of growth has not been even. The periods of greatest growth being the sixties, the eighties and nineties. The sixties were the first period of sustained economic growth after the end of the second world war. During that decade the number of unit trusts grew from 51 valued at £210m to 240 valued at £1,397m. This growth of some 500% in the number of funds compared with a drop of almost50% in the period from 1940 to 1960. The growth went on through the seventies by the end of which time the number of funds had reached 443 and their value £3,936m, although in considering that value figure we should remember the high rates of inflation that existed in the seventies.
Two important structural changes happened in 1979. The first was the deregulation of charges and the second was the disappearance of exchange control regulations. These combined with the raging bull market that existed through a good part of the eighties, the opening of investment into a wide range of foreign markets and the entrance of the large insurance companies into unit trusts saw the industry grow to 1407 funds by 1990 with a value of £46,342m. By the end of 1995 those figures had increased to 1633 funds valued at £112,631m. In other words the first half of this decade saw a 14% increase in the number of funds, a 140% increase in values. Without doubt the biggest single contributory factor in this growth has been the personal equity plan.
Regulating Unit Trusts
On the regulatory front the most significant change was the passing of the Financial Services Act 1986. Up until then the industry had been regulated, on fairly light rein, by the Department of Trade and Industry. Looking back at those days, with the benefit of hindsight, one has to acknowledge that there was a more laisser faire attitude. Yet, the fact remains that there were no major scandals. To no small degree the industry operated on a system of trust between managers and trustees.
Recent regulatory developments
The SIB unit trust regulations, which created a much more prescriptive environment, have undergone a number of significant changes since they were first introduced. For example the investment and borrowing powers and the dealing and valuation rules moved from separate statutory instruments into the regulations. There have been a number of changes in hedging and the use of derivatives and, in addition, we have seen the range of authorised trusts widened to include assets such as real property and derivatives. More recently, that is within the last two years, we have seen a number of changes which have been classified as `deregulation`. Logically that should mean that there is less regulation because something has been taken out of the scope of the rules. Yet this, in my view, is not what has happened.
There is no doubt that the biggest single problem in unit trusts, since the FSA regulations came into being, has been the handling of pricing errors. Initially the regulators viewed unit trust pricing more as an exact science than an accurate estimate. This meant that far too often the cost of investigating and correcting an error was way in excess of the amount of compensation. Also regulators placed too great an emphasis on the trustee double checking the actual computation of a unit price. When they did accept that pricing is more of an art than a science and brought in a degree of materiality they `deregulated` by putting the onus of deciding on the adequacy of a manager’s pricing methodology on the trustee. Now it can be argued, and I would do so, that the basic tenets of an acceptable pricing methodology are no more than those than any manager who claims to be fit and proper to carry out that role should have adopted in any event. So why make the trustee responsible for what should be a basic requirement of any fit and proper manager? Pricing errors still happen and always will happen because pricing is carried out by human beings.
The second area is the eligible markets regime. Here the regulators decided they were not best qualified to decide if a stock market was right for investing more than 10% of a unit trust. That was a decision for the manager under the duty of oversight of the trustee. But, instead of one body checking on a market you have all managers using that market making the same checks. Also, because of the UCITS effect, markets in Athens and Lisbon are automatically acceptable whereas New York and Tokyo are not. There are valid reasons why the decision on a market should be made by the party making the investment – that is the manager – but there is a need to build in some mechanism that allows this to happen but avoids unnecessary duplication of effort. It is hoped that the current review by IMRO will achieve this result.
The third example is negative boxes. Quite rightly a negative box is seen as a serious breach of the rules. For a manager to sell units where they do not exist, that is where the money is not in the fund, is serious if it goes unnoticed and uncorrected. Yet, once again, we come up against the such fallibility of the human being. Mistakes do happen. Most are quite innocent and should be allowed to be put right without penalising the manager. The regulators ‘ proposals allow this to be done within limits but, once again, the trustee is made responsible for acting as referee for something that is the prime duty of the manager. Not only that but the trustee has to report the facts to the regulator whether or not any restitution is due to the fund. These are all valid changes but I would not describe them as `deregulation`.
Another important change has been the increased emphasis placed on disclosure. No-one should quarrel with the idea that a prospective investor is entitled to be given sufficient information about the rights, the costs and the risks that attach to an investment. One of the major problems has been the allied objective of trying to ensure that disclosure is standardised. Investment products are not all the same and it is neither possible nor indeed desirable to try and force common disclosure methodology on disparate products despite what the OFT may think.
The changing regulatory approach
We have seen the first steps being taken down the road of greater disclosure and less regulation with proposed regime for open ended investment companies. Companies will have to publish their charges and their policy on the possible impact of dilution. For a long time now, many have thought that unit trusts have been sold without adequate information being given about the risks that the investor ought to accept. This has been particularly true of risks that emanate from emerging markets. It must be reasonable to expect that someone willing to invest in countries where there are potential economic or political problems should understand that they cannot be totally protected from those risks. It is neither logical nor equitable to expect the trustee or depository to accept all the risks on behalf of the investor. That does not mean that the trustee/depository should not take all reasonable steps to protect the assets under its control but if a market operates in a certain way and that approach has a higher degree of risk then that risk must lie with the investor.
Another major change with the open ended company is the move to single pricing. There is one point arising from single pricing that does need to be understood. This is that the proposed method has been selected because of its simplicity and marketability .There is nothing wrong with this. It is a valid approach. However, if those two criteria are to be given increasing emphasis in the design of the product then they must be taken into account in deciding the correct regulatory system.
What lies ahead
Some further changes in collective investment schemes are likely to be seen over the next year or two. The most interesting, and potentially the most controversial, is single pricing for unit trusts. We are all only too familiar with the long and inconclusive debate on this subject. A debate that was dominated by one topic. This was whether or not single pricing must bring with it dilution and therefore be disadvantageous to those investors who remain in the fund. The current view is that the dilution problem was over-stated and, whilst it can arise in some instances, it should not be allowed to be the dominating factor in deciding on the pricing mechanism. The real question is should the present dual pricing system be replaced by single pricing and should that system become mandatory? Or should investors and managers be allowed to decide if they want single pricing? If pressed to give a forecast I would expect single pricing to become mandatory although there will be a generous transitional period.
Revising the UK regulations takes a long time but revising the EU regulations takes even longer. For some time the UK has wanted to include feeder funds in UCITS because they see it as a good way to sell UK funds to foreign investors. But its case is weakened because at present the feeder fund has only a limited use in this country. There is pressure therefore for a widening of the feeder fund regulations. Not only does the industry think it will help their case in Brussels but it will assist in what is fast becoming a buzz word over here which is `branding`.
The SIB Discussion Paper of late 1993 raised the topic of guarantee funds. It said that there had to be external guarantees from financial institutions. There is a demand for this type of fund to be made available but there is also the view being put forward that the guarantee, either or all or part of the fund, could come from derivatives rather than external guarantees. Closely linked to guaranteed funds is the question of limited issue and closed funds. Under the UCITS Directive it is not possible to restrict the redemption of units or shares. Limiting sale of shares is not such a problem. However, if this type of fund were allowed in the UK and they were not UCITS funds then it appears possible to market them here.
That, in turn, leads on to the desire to see the range of funds widened. This applies more to open-ended companies than it does to unit trusts because the new format is likely to be the most attractive option for such funds. The Treasury has indicated a willingness to try and find ways of widening the scope of companies beyond those allowed under the UCITS Directive. If this proves possible then it would encompass money market funds, funds of funds, futures and options funds, property funds as well as closed or limited issue funds.
Another topic which has been raised in the past and which is likely to come to fore again is that of performance related fees. Sill indicated that they would be prepared to consider a peak to peak system for GFOFs. However, I do not see the proponents of this form of remuneration being satisfied with just that small slice of the cake. They will want to extend it to other types of funds and they will want to have a system based on bench marks and not just peak to peak. This is potentially the most complex of all the likely changes and I suspect may take a long time to come. There is likely to be resistance from the consumer lobby to anything which might lead to managers operating a `heads we win and tails you lose` system.
Do we have the right regulatory framework
Continuing my look into the future I want to consider the regulatory regime and in particular whether there is a need to change the present system and if there is what type of system should replace it. Authorised unit trusts have been controlled by trust law and, since 1988, by a very prescriptive regulatory system. That some people find comfort in prescription is undeniable. Equally there are others who believe that regulation should be based upon acceptance of certain basic principles and that the regulations should be no more than the framework within which the practitioner operates.
The question as to whether the present regulatory system is the most effective one is being asked with increasing frequency as we approach a general election and as it becomes clear that there is a difference of approach between the main political parties. The present government party opted for a self-regulatory system which gave a large if not dominant role to industry practitioners. It opted, also, for a system where the day-to-day regulation is delegated by Government to a primary regulator and to a number of SROs and RPBs. Has this approach been effective? But before answering it one has to ask by what yardstick you measure effectiveness. The answer, in my view, is the ability of the system to protect efficiently and cost effectively, the investor from loss by fraud, neglect or deliberate mis-selling. A regime which has seen the Maxwell fiasco, the losses arising from home owner income schemes and the mis-selling of personal pensions cannot be judged a total success. At times it has been slow to react, heavily bureaucratic, inconsistent and costly to maintain.
I do not want to move away from the present system without some positive remarks. In particular I would acknowledge the helpful and constructive way in which the present representatives of the regulators approach their roles. It has been refreshing to see the way in which they have shown themselves willing to discuss not only the present regime but also how it may be developed. They have also shown a willingness to appear in public to discuss and debate topics of current and future interest to the industry.
Before the right regulatory system can be introduced there has to be a clear idea as to what it should seek to achieve. It is the fashion these days for organisations to have what are called `mission statements`. If that approach were to be applied to the regulatory system then maybe its mission statement should read along these lines. `To ensure through the suitability, strength and expertise of the product providers and by full disclosure that investors are protected against loss through mis-selling, fraud or neglect.` Having identified the overall mission one can move on to decide how it should be achieved.
An alternative approach
It is argued by some that this country should adopt the US SEC system. This overlooks the fact that the UK is not the US and that because a system operates in one country it must operate just as well in another country. If we have made any progress at all in the last decade, and I believe that we have, then there is no sense in throwing the baby out with the bath water. What we need is a single regulator with primary responsibility to Government for all aspects of regulation. If this means taking away the special treatment allowed to the professions, then so be it. The body that can fill this role exists already. It is called the SIB. The SROs would disappear and the RPBs would give up their roles under the FSA. The board of the SIB would be made up of independent people nominated by the Government after consultation with the financial services industry and consumer bodies but no-one would represent any vested interest. The terms of reference for SIB would require them to set up consultative bodies so that the views of professionals and consumers were taken into account on decision making.
The single regulator would be required to set standards and core rules and to give clear guidance as to how it considered those standards and rules be met. This would give a best working practice imprint to those standards and any individual or organisation which failed to meet them would be in automatic breach of the regulations and would face the appropriate punishment. There would be a move away from prescriptive rule making with its emphasis on check lists and reams of paper all held by a series of different people just to prove that they had done what they were supposed to have done. In its place would be a regime that concentrated on. setting standards, controlling very tightly who could operate in financial services, the financial strength to meet potential claims and severe penalties for those who broke the rules.
Anyone wishing to be a practitioner in financial services would have to satisfy the regulator both as to their fitness, based upon their past record, and that their knowledge and experience was sufficient to allow them to carry out the role they were to fill. Anyone given authorisation who then fell short of those standards should be subject to suspension or disqualification or, in the most serious cases, to civil prosecution.
The second requirement would be that every firm that sought to provide some form of financial service should be required either to have a capitalisation sufficient to meet its potential obligations or to have those risks insured. Today there is too much of the `nanny state` syndrome that argues that if there is no-one else who can be made to pay up then it must be the Government or, in actuality, the taxpayers. This cannot be right. What is needed is an ongoing assessment of the liabilities of the firm, not just as they affect its direct creditors, but including the results of wrong advice, negligence, fraud and other losses that its clients may suffer through its actions. It is the total liability that needs to be covered.
Allied to this there must be a clear allocation of responsibilities and any party which is given a direct responsibility must be the one which is directly accountable to the regulators and the investors for their actions. In the context of collective investment schemes this would mean that unit trust manager or the open-ended company and its directors would be directly responsible for tasks such as buying and selling units or shares, for investing funds, for accounting and reporting to investors and for registration. The trustee or depository would be directly responsible for custody of the assets, for collecting income and securing certain overseas tax reclaims. Pricing of units or shares would be the only exception to this approach. There the manager/company would have primary responsibility but the trustee/depository would have an audit function to ensure that the manager did price properly and did account to the fund and the investors at the right price and at the right time.
It is all very well having the right framework for firms already in or wanting to come into the industry and for ensuring that they operate within the spirit and scope of the rules. But not everyone in any organisation is at the same level. This means that the key roles have to be identified and it is those people who have to have proper qualifications and experience. A filing clerk does not need to understand how the derivative market in Tokyo operates but a derivatives fund manager certainly does need to have that knowledge. This brings with it a requirement for there to be identified qualifications which must be held by anyone wishing to hold defined positions. Also, there needs to be ongoing training and every employee must be given the time to meet that requirement. Failure by an employer to provide time would be a breach of the rules and failure by an employee to use that time would be treated in the same way as a lack of proper qualification.
The last ingredient, not in value, but in this list, is disclosure. This is vital. Unless you tell the investor what it is the product is designed to achieve, what it will cost to buy and to operate and what risks have to be taken on board because they are inherent in the product, you cannot hope or expect investors to understand it, to be able to make intelligent decisions about it or to be willing to accept their share of the responsibilities that go with it.
What does the future hold?
I would like to end with a little crystal ball gazing and offer some thoughts upon how I see collective investment schemes developing as we approach the next millennium and how I see the role of the trustee being affected by those developments. I mentioned earlier a number of areas where it is likely that we shall see changes in the collective investment schemes. These included open-ended investment companies, single pricing in unit trusts, wider use of feeder funds, limited issue and guarantee funds and performance related fees. As you will have noticed there is a common thread that links nearly all those topics. It is the widening of the range of the products available. Perhaps the greatest challenge that has faced the unit trust industry since it came into being is the increased competition from alternative home based products and, more recently, from products that are domiciled in other countries but which are marketed in this country. If the home-based industry is to not only increase its market but is to survive at all, it must have products that meet the requirements of investors at home and overseas. Change may be our continuous but it does not mean that all change is progress. However, it is no longer possible to sustain the argument that as unit trusts have worked well for sixty plus years there is no need to make any changes or to enlarge the product range. One has to look no further than to the proportion of the home-based savings market that has been attracted to unit trusts to see that they have not achieved anything like the market penetration they should have won.
The reason for this must be that unit trusts have not offered the public products that have met its requirements. Originally, of course, they were designed to allow the small investor to have an interest in stocks and shares when direct investment was not practicable because of lack of funds. However, the world has moved on since then and now the industry needs to ask itself what it is the investing public wants today. When that is known the product providers should make sure that they are offering the right product to the right market at the right price. PEPs have been a good illustration of this. Their attraction has been their tax efficiency and everyone is keen to avoid paying tax if they can. If we are passing through a long period of low inflation and approaching a time when it is going to be necessary for people to save more for their old age then there must be golden opportunities for collective investment schemes. Many people have seen the disadvantages that come the `go go` and `grab what you can` attitudes of the eighties. They are now more cautious and risk averse. Therefore, collective investment schemes must reflect those feelings. Also, if the industry is to attract a wider public it is going to be necessary to speed up and simplify the buying and selling of units or shares. By that I mean an instant payment of the proceeds of realisation so that it will be as easy to get your money as it is to draw cash out of a hole in the wall. Indeed, I would go so far as to suggest that it should be possible to transact a deal in a collective investment scheme in that very way. Then of course there is the internet. If we believe all we hear about that we shall be able to do all our financial transactions without ever getting out of our armchair!
To meet the widely varying needs and aspiration of investors, collective investment schemes of the future must offer a wide range of options so that they can satisfy the cautious and the adventurous. The industry cannot achieve this on its own. It has to have encouragement from Government in the form of a legal and regulatory framework and a tax system that is simple, effective and flexible. If these objectives can be achieved then there is no reason why collective investment schemes in the third millennium should not be a story of continuing success and growth.
But what of trustees? As we near the introduction of open-ended companies one hears the view that, given single pricing for unit trusts, there is no need for this new product. That is not a view I share. The trust format has served the investing public well. However, that does not make it the most effective method. The only criteria that should be applied to any format is whether it can operate simply and cost effectively and provide the level of investor protection that is required. If a if trust, through its concept and application, helps to create a product that is not understood or accepted by investors or is not suitable for the product being sold, then it should not be used.
I think that having served investors well the trust from format will decrease in popularity and may well become obsolete within the next ten to twenty years. Does that make the trustee an endangered species? In a sense I suppose it does. Yet, if one door closes another will open. The skills and integrity that trustees have brought to unit trusts will be needed as much, if not more, in the new world opening before us. Their name may change but their contribution will continue to be of the highest value to.investors. I am sure that TACT and its members will meet those new challenges with all the skill and determination as in the past and I wish the Association and its members every success in this world of continuous change.
© Brian Wright