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History Policy Papers

A New Regime for Asset Management: Why the UK should adopt a Dual Funds Regime

The New City Initiative (NCI) was formed to provide a collective voice for smaller boutique managers which were being overlooked by policymakers, regulators and to a lesser extent customers, who did not always appreciate the strong alignment of interests and risk management culture that differentiates boutiques from larger firms.

Recent years have seen waves of regulation and boutiques have shown the flexibility required to deal with this despitetheir smaller size. Post-Brexit, we operate in a world of “VUCA” – Volatility, Uncertainty, Complexity and Ambiguity. This presents challenges for all firms, but therein lies the opportunity.

The exact regulatory and competitive landscape is still to be finalised. It is therefore vital that the industry puts forwardideas and potential solutions for debate and that those responsible for shaping the agenda, negotiating terms and planning for the future, open a dialogue with all participants. In this paper, the NCI outlines how an agile and thoughtfullyconsidered dual funds regime in the UK could help firms retain EU access, but also expand and grow beyond the EU.

This regime – as the paper points out – would allow for further innovation by UK managers in a global marketplace. Fund management is one of the UK’s most successful exports, and we feel a dual regime respecting both UK and EU interests, can bring about new opportunities and be practical, proportionate and fully protective of consumer interests.

The key for all businesses, not just within financial services, is clarity and certainty, and this must be provided by the government. The financial infrastructure and regulation of the UK is so intertwined with Europe that Brexit will require time and patience to implement effectively. This paper provides one solution which could be implemented with relative ease.

Jamie Carter

Deputy Chairman, New City Initiative Chief Executive, Oldfield Partners

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Policy Papers

The Moral Case for Asset Management

It is no secret that the public despises bankers. Throughout history, the concept of banking and investing has always beentarnished with an image of individuals profiting from speculation or human misery – fund managers (especially hedge funds) ‘don’t make anything – don’t do anything’ and that ultimately our industry is one which exists solely to generate profits for ourselves with no benefit to our communities or mankind at large.

However, in my mind, it is the fund managers – these allocators of capital – who make the whole system work. Without capitalism and the difficult task of putting money to work where it will generate the highest rate of risk adjusted return – we would have had far fewer inventions, human advances, and wealth creation for society as a whole.

This paper, written by Richard Turnbull, goes into great detail as to why this is true. Fund managers provide liquidity, expertise, risk reduction and are also better structured to create the right culture of service and long term thinking. This helps fund managers avoid exactly the accusations of short termist speculation that are often levelled against us. Ourability to retire with dignity or fund new technologies depend upon our industry flourishing in the right way.

The problem with capitalism, as we are seeing with current events such as the vote against the EU by Britain, is that it means in many cases, brutal changes for those areas of the economy which cannot deliver the efficient returns. This means people’s lives change and this can be both incredibly painful and has long term social and financial ramifications too. To respond to these valid issues, a more sympathetic approach to investing which understands the effects of these changes (such as ESG investing) is now being pioneered, by the investing community and we at the NCI welcome this. This does not negate the need to generate returns for investors – but an understanding as regards the effects of our decisions is a good thing.

Finally – there is a view that the people behind some of these firms carry less moral weight than someone in a more vocational profession. We would dispute this, believing that taking thoughtful and difficult decisions to allocate savers’ funds to generate the best possible returns, is in itself both a hard task and one with an enormous positive outcome for savers and therefore society. We all need to generate better cultures and the NCI has taken a strong lead on this – but at the end of the day I believe that fund management is a powerful force for good and it is time that we started to celebrate our contribution both to global finance and the world at large.

I would like to thank Richard Turnbull for his excellent work here and for the engagement he brought to our group through the interviews he undertook and the fresh perspectives he generated via his links with the Centre for Enterprise, Markets and Ethics. His Centre has an important task ahead of it and we welcome the partnership we have formed together.

Dominic Johnson
Chairman, New City Initiative and CEO, Somerset Capital Management

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Policy Papers

The Changing Face of Foreign Exchange

The last few years have been turbulent times for all those involved in the financial markets as they come to terms with all the changes in regulation, market behaviour and market practice. In the past, buy-side institutions such as institutional investors, pension funds, asset managers, wealth managers and private banks have tended to be immune from any turmoil. This time is completely different as the changes are more far-reaching and the upheaval is having a significant impact on all financial market participants, but it has come as a particularly major shock to the fund management industry.

Clearly there has been an increase in costs as a result of compliance with the new risk and regulatory regime. Frequently, additional resources are required to meet the extra administrative burdens associated with doing business in the current environment. Undoubtedly these do not fall fairly across the spectrum of institutions involved and become a barrier to entry for new specialist entrants.

One way institutional investors and asset managers can turn this new business environment to their advantage is in the area of FX. These new regulatory changes are a unique opportunity to upgrade their business model, their FX operational processes and improve efficiency to reduce investment costs and improve fund performance.

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Policy Papers

The Next Five Years: Regulatory Challenges That Will Impact Asset Managers

The New City Initiative was established to both promulgate our vision for better alignment between investors and money managers – but also to give positive steer to regulators and governments as to how to achieve this. This paper outlines clearly the issues confronting our industry over the coming years and where we would either draw our members’ attention to certain issues, or where we think the regulatory framework could be better structured. Wellington talked about ‘The Other Side of The Hill’ and I hope this document gives some clue as to what is in store for our firms in the near and medium term.

What we find, time and time again is that regulations designed to do one thing (make for a ‘safer world’) actually end up doing the exact opposite – normally destroying competition, making the larger firms larger and thus potentially reducing returns to investors, customer retention, and making the whole system more delicate. The powers that be have oftenmisunderstood what ‘risk’ is and how it is up to a market to price it properly. Much of their efforts to somehow ‘control’ risk, either force it into dark corners where it cannot be easily seen or reduce liquidity in a market, where the real and ultimate risk (as seen in 2008) is a liquidity crisis. We continue to argue that better structures and culture lead to better outcomes and we remain committed to the path of less regulation and more forcing of a change in how people ‘think and operate’ to achieve these same goals of managing risks and being more transparent.

Our view is to promote positive change and I hope that you will find in this paper not only a new set of worries but also a set of quite simple answers to help us make for a better environment in financial services.

Dominic Johnson

Chairman, New City Initiative
CEO and Founding Partner of Somerset Capital Management LLP

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History Policy Papers

Asset management in Europe: The case for reform

The key trade-off for any business is that of costs versus income. The issues surrounding regulation are very similar – businesses need to operate in a regulated market, but the benefits of regulation need to outweigh the costs. This premise is very relevant for the European Union project. The free trade zone initially created by the European Economic Community (EEC) and the efficiencies (supposedly) generated by a single currency, all should lead to an increase in trade, benefitting all concerned.

However, the investment management community and especially the ‘boutique’ (i.e. smaller firms) community find that the regulatory burden imposed upon us by the EU (AIFMD, MiFID II, etc.) is so expensive and onerous, that in themselves these regulations are an issue in terms of our business sector prospering. We also find that the implied benefits of an open and free trade zone are largely illusory. As companies trying to sell our products across Europe, we are constantly obstructed by an uneven application of the law, ignorance of the free trade rules, and in some cases protectionism. In this paper, this is clearly illustrated in our case studies of accessing Germany and Slovenia. The costs of the regulations in many instances outweigh the advantages.

This is a serious situation to find ourselves in, and in collaboration with Open Europe we wanted to bring a positive case for reform in Europe at a time when both the economic and political basis of the principal of Europe are coming under increasing pressure. We have laid out in this paper a clear series of changes we would like to see made, as well as illustrated the barriers we currently experience to a ‘proper’ free trade zone in Europe. We have specifically avoided trying to make political judgements, leaving that for the politicians, but we do believe that bigger, freer trade zones, properly regulated, are highly desirable for all members of the New City Initiative and we hope that our thoughts here help us achieve this goal.

Dominic Johnson

Chairman, New City Initiative
CEO and Founding Partner of Somerset Capital Management LLP

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History Policy Papers

How Regulation is Damaging Competition in Asset Management

  1. The UK SME asset management sector has traditionally been vibrant and strongly growing, but it is now stagnating, as new start-ups cannot support the financial cost resulting from increasing regulation.
  2. Boutique asset and wealth management firms find the burden of regulatory compliance increasingly onerous.
  3. New financial regulations from the EU and UK are applied equally to the very biggest and smallest asset management firms, disregarding their ability to shoulder the consequent financial and legal burdens.
  4. If financial regulation is not imposed more proportionately on large and small asset management firms, the NCI is convinced that many fewer start-up firms will come to market. This arrest of competition will damage all, but especially the consumer, as choice will become much more limited.
  5. The legal complexity of and the potential financial punishment for infringements of regulation pose massive obstacles to the growth of competition in this sector.
  6. A new ‘priesthood’ – compliance officers – has emerged from the financial crash. As the regulatory regime becomes ever-complex and continually evolves, and the scale of potential punishments so damaging to small firms, the temptation is for compliance officers to engage in ‘gold-plating’ to avoid any possibility of failure to comply.
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Policy Papers

Les Patrons Mangent Ici: A practical guide to better alignment in the financial services industry

As the financial services industry seeks to rebuild itself in the wake of the global financial crisis, the need to find new ways to manage risk becomes a greater part of the debate. With national governments, the European Union, and various global associations and supranational bodies all looking at additional ways to regulate the industry, this paper examines whether there is an alternative, and perhaps more effective, route to reforming the industry through the encouragement and incentivisation of behavioural change.

Better alignment of managers with their clients can reduce risk, improve performance, and rebuild trust in the financial services industry. We do not believe that this should be accomplished by additional regulation on remuneration or ownership, but rather through a process of cultural change and increased transparency. The aim of this paper is to offer practical suggestions about how investment managers can become better aligned with their clients, drawing on our experience as financial SMEs for whom this is a fundamental tenet of our businesses. We then explore how these suggestions can be applied to participants in the financial system more broadly. Finally, we offer suggestions to policymakers on how they can encourage better alignment within the financial system.

Policy Responses:

Response 1

Support and accreditation by regulators and industry stakeholders for the establishment of a ‘Code of Good Practice’ for the fund management industry.

Response 2

Deferral of income tax on remuneration fund managers are compelled to invest into their own funds, and limited deferral on voluntary co-investment in order to encourage alignment.

Response 3

Simplification of the regulations around making employees partners in financial LLPs, and encouraging employee ownership further in both companies and LLPs in line with policymakers’ efforts to increase employee ownership more broadly.

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Policy Papers

Passive or Aggressive? Why the Growth In Tracking Products Should Concern the Industry and Investors

The explosive growth of Exchange Traded Funds (ETF) over the last decade is the latest in a long line of financial innovations to come out of the investment banks who, over the last five years, have seen many of their traditional revenue streams evaporate. Behind these apparently simple, easy and cheap financial vehicles there are armies of traders employed in their ‘construction’. It would not be too far from the truth to say that swaps, futures and stock lending departments now rely for their very existence on the increasing appetite for the ETF.

The purpose of this short note is to point out the downside of this latest of financial innovations. The marketing and lobbying muscle of the investment banking fraternity has been extremely effective at highlighting the advantage to investors of the ETF. The potential downsides of these instruments are less often heard.

Since Jack Bogle launched the First Index Investment Trust in 1976, assets in tracking products have grown from just $11 million to over $1.5 trillion today. Whilst these funds initially focused on equity indices such as the S&P 500, there has recently been an explosion of products in more esoteric and illiquid markets, with ETFs accounting for a large proportion of this growth (ETF AUM has increased by 40% p.a. over the last decade). Investors can now buy ETFs in anything ranging from agricultural commodities to one providing leveraged exposure to volatility.

The growth of ETFs has been embraced with relish by the financial services industry and such products now constitute a highly profitable earnings stream. For investment banks, profit margins on ETFs are significantly higher than on traditional actively managed products. Beyond management fees, issuers make extra profits through securities lending, swap origination and futures sales. The high profitability of ETFs creates a powerful incentive for issuers to continue aggressively expanding the number of markets and assets that ETFs purport to track, regardless of whether this is to the benefit of investors and securities’ markets in general.

Good ideas taken too far would be an apt summary of the history of financial innovation. While the ability of investors to gain exposure to a broad array of asset classes at a low cost should be seen as a positive development, the enormous increase in both the scale and scope of ETFs brings with it a number of dangers, which need to be considered by both investors and regulators. Such dangers affect both broader market participants in the form of higher volatility and higher stock correlations, as well as higher valuations of indexed stocks. Investors in ETFs are also exposed to counterparty risk and in certain asset classes, returns far below those of the underlying assets.

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Policy Papers

Start Up Britain is Here in London: Why it is crucial to support financial SMEs

The impetus for this paper arose in a most unlikely manner. At a meeting with the NCI, the Business Secretary Dr. Vince Cable asked about the scale of small and medium sized financial services businesses, and how many jobs this sector provided, in the capital. Nobody had the answer. The Board of the New City Initiative promised to find out and to report back to the Secretary of State. With the significant assistance of IMAS Corporate Advisors and the Lord Mayor’s office, we delved into the data, and found that this interesting question revealed some surprising statistics. We therefore thank the Business Secretary for inadvertently initiating our latest policy paper, which we hope will fill some gaps in knowledge about this robust and thriving section of the financial services sector in the UK (and indeed by inference in Europe more widely). As this paper will demonstrate, the so-called “City” is far from being about the financial giants alone.

Taxpayers were called upon to bail out ‘big banks’ after the financial crisis, leading many voters to resent the financial services industry bitterly. But there is another City. It is made up of entrepreneurs who manage significant sums on behalf of investors and employ many tens of thousands of people. Some of us have come together to form the NCI, whose members alone have some £200 billion under management and employ several thousand individuals.

However we represent but a small part of the diverse body of financial SMEs that contribute to the City. According to our research sources, the financial SME sector (typically defined as firms employing less than 250 employees) as a whole employs up to an astonishing 57 per cent of the UK’s total financial services staff. Accurate figures for assets under management are harder to come by, but the UK’s Financial Services Authority (FSA) suggests that UK-based hedge funds alone manage some $550 billion.1 In Europe as a whole, it is estimated that the hedge fund industry – just one category of the SME sector – employs 50,000 people across the EU, and that their partners, employees, consultants and service providers pay taxes of more than $8 billion every year.2 Clearly this is just the beginning as far as the wider financial SME sector is concerned across Europe.

We believe that financial entrepreneurs are a valuable asset for the UK and wider EU at a time when economic growth, particularly outside the European core, cannot be taken for granted. Given the rise of emerging economies and the pressing need for developed nations to compete, SMEs are vital because they stimulate excellence and hence competitiveness within the financial services sector.

In the light of financial SMEs’ significant roles as employers and innovators, as discussed further below, we believe that there is a vital need for regulators to ensure that the new regulatory framework distinguishes between different kinds of financial businesses with a particular focus on the levels of risks they may (or may not) create for the financial system. This will help the City and financial centres throughout Europe to thrive as valuable economic assets for their own countries and for the EU more widely. The alternative is to expose Europe’s financial centres to avoidable competition from offshore regimes such as those in Switzerland and many emerging markets, where the authorities aim to attract institutions through lighter regulatory and tax burdens.

This paper covers lots of ground, but it focuses on one key point. We must avoid imposing regulations designed for banks and shadow banks on SMEs.

The first step towards this is to correct the misconception – common in policymaking and regulatory circles in both the UK and Europe more widely – that the financial sector consists solely of big banks. When regulators and other officials deal with financial services companies, they must distinguish between two categories. The first includes those businesses which use their balance sheets for trading purposes. The second is comprised of companies that do not – which are, effectively, third-party advisers – and which also demonstrate a strong focus on alignment with their clients. The UK government set out its commitment to small businesses of all industries in its budget of March 2011, although many would argue that its proposals did not go far enough. With this principle established, we would like to see measures taken to encourage SMEs in the financial services sector specifically, based on the key distinction identified above.

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Policy Papers

The significance of the SME sector in the UK Financial Services industry

The SME sector remains a vital component of the UK financial services sector employing over 350,000 people.

Based on analysis using IMAS-insight, IMAS estimates that the SME sector employs over 350,000 people across a range of organisation sizes including 50-250 employees (c. 30%) and 10-50 employees (c. 15%).

The estimate is based on data from the FSA Register for FSA Approved Persons where employee data is not available, as well as statistical averages where no company employee or Approved Person data is publically available.

The SME financial services sector in asset management has demonstrated strong resilience through the downturn

Within the asset management sector (fund managers and private client wealth managers), the SME sector has consistently grown its share of employment of FSA Approved Persons since 2007 to over 45% of the market.

In addition, the SME sector has shown greater resilience through the downturn compared to the Large Cap sector. The SME sector demonstrated both higher growth than the Large Cap sector in 2008 & 2009 as well as a lower contraction than Large Cap in 2010.

The SME sector has grown female employment of FSA Approved Persons in the downturn against falls in the Large Cap sector

In the 2007 to 2009 period, the SME sector grew female FSA Approved Persons by 16%, compared to falls of 5% in the Large Cap sector.

This has also enabled the SME sector to steadily grow its female mix of FSA Approved Persons from 13.4% in 2007 to 13.8% in 2009.