Simon and Daniel’s article was published in Professional Pensions on 4 September 2018 and can be found here.

The traditional role of an asset manager appears uncontroversial: they handle their clients’ investments, manage them effectively and make appropriate recommendations. To do this, they use their judgment and experience supplemented by analytical research and forecasts. But there is growing concern that some trustees may have been misled by their asset managers and overcharged for services rendered.

The UK asset management industry has around £6.9trn under management – of which approximately £3trn is managed on behalf of UK pension funds and other institutional investors. Many of these assets are held either in tracker funds or actively managed funds.

Tracker funds are largely automated, tracking the performance of an index, such as the FTSE 100 or the FTSE 250, which has consistently outperformed its blue-chip rival over the last two decades. Conversely, actively managed funds have a greater human element. Fund managers and investment research teams make investment decisions. Their aim is to outperform the market and generate a return over and above a tracker fund. Because of the skill and time involved, a higher fee is charged.

Price competition

There has been much concern over how asset managers execute their responsibilities and many fear that overcharging is systemic. In response, the Financial Conduct Authority (FCA) undertook a wide-ranging review. Published in June 2017, the FCA’s final report found that price competition is weak across the industry. Despite a multiplicity of firms operating in the market, managers have enjoyed high profits over many years.

The report also found no clear correlation between the charges levied by an asset manager and the performance achieved by the funds that they managed. This suggests that the well-worn adage “you get what you pay for” does not seem to apply when it comes to asset management.

The FCA’s report said around £109bn is invested in funds which claim to be actively managed, but which closely mirror the performance of the market indices: they appear to perform more like a tracker fund would. Such funds are known as ‘closet trackers’ or ‘index-hugging’.

A widely-held belief is that, although asset managers are charging for active management, there is in many cases no active element being applied. Instead, many funds are simply tracking market indices: something which is easily done by a computer at a much lower cost.

The scale of the issue is startling, particularly when considered alongside the vast amounts under management. Some observers believe that the closet tracker scandal will rival other scandals in the financial sector such as PPI mis-selling. If that proves to be correct, the potential consequences for the perpetrators will be very serious indeed.

Pension trustees must sit up and take note of this. This is because pension funds may be sitting on claims with enormous potential value. Given their fiduciary duty to act in the best interests of the beneficiaries, trustees have to respond and ask themselves whether their schemes might have invested in so-called closet tracker funds. Trustees would be well advised to investigate further, and it may even be appropriate for them to consider bringing meritorious legal claims for the benefit of the scheme.

Investors in a fund that has been marketed, sold and charged as an actively managed fund, but has instead been operated as a tracker fund, would be entitled to recover damages from the asset manager. In essence, the manager has not performed a service for which it was paid.

Recompense

So what recompense might there be? Without recourse to formal legal proceedings, investors would potentially be entitled to full reimbursement of the overcharged fees stretching back six years. If it can be shown that active management would, or could, have led to a higher return for the investor compared to a tracker fund, then the potential damages could be eye-watering.

Many of the UK’s largest pension funds may be sitting on valuable claims. Any recoveries made from such legal claims would be a welcome development for the pensions industry, particularly when so many schemes are in deficit.

Of course, trustees tend to view litigation with some caution. And rightly so: it is notoriously expensive and inherently risky. There are, however, way and means of resolving claims without the need for full-blown proceedings, so as to maintain confidentiality and long-term commercial relationships. There is also an array of options available to parties holding meritorious legal claims to finance the legal costs of pursuing them, and insuring against the downside risk, such that the advantages of pursuing a valuable claim far outweigh the perceived disadvantages. In short, this is not an issue that trustees should ignore.