IndexUniverse.eu: Several experts have pointed out the inadequacy of conventional measures of fund cost—total expense ratios don’t reflect the effect of investment turnover, for example. With all this increased focus on cheaper investing, does it matter that we can’t agree on what low-cost actually means?
Mackay: I don’t think the average retail investor understands the total expense ratio (TER) at all. Personally, I’ve always favoured looking at the total cost of investment, where the effects of turnover are shown. But I’ve yet to see fund managers or independent experts put forward an effective way of measuring that. Perhaps a total cost figure is an ideal that can’t be achieved in practice. In the meantime, we’ll all fall back on TER as a reasonable starting point, though it’s not perfect.
When we consider whether costs are reasonable or not, the subject of complex and non-complex investment products also rears its ugly head. The European securities regulator (ESMA) has decided it's not going to make a ruling on the subject, leaving the topic to form part of the ongoing review of the Markets in Financial Instruments Directive (MiFID II).
I think it would be a good thing for the industry to come up with some kind of definition of complex and non-complex products by itself. By doing this, asset management firms would start to regain the trust both of retail investors and advisors. I think a lot of advisors are very concerned about what’s going into some portfolios. Advisors also struggle to understand some fund structures and such uncertainty can’t help anyone.
You’ll have heard all the arguments from the fund industry as to why such a common definition can’t be reached. But in my opinion if fund managers can’t agree, then the regulators will come up with a definition that’s heavier handed, harder to implement and more expensive.
IndexUniverse.eu: BlackRock suggested last year that physically replicated ETFs and derivatives-based ETFs should be classified as fundamentally different. In its ETF guidelines, ESMA has ignored this suggestion as it seems to have no appetite to split the UCITS fund market into two parts, which such a classification would suggest. What do you make of all this?
Mackay: Yes, in effect it would have been necessary for the regulators to step back a few years and rewrite the rules on eligible investments.
The first version of UCITS, which came into force in 1985, was very well accepted. Over time, it became clear that some modifications and extensions of the rules were required. But when UCITS III came into force in the last decade all funds became reclassified automatically as UCITS III-compliant. That, in turn, meant the expansion of the type and range of investments they could use to include derivatives.
With hindsight, it might have been better to have kept UCITS I funds as they were and to have allowed only newer, UCITS III funds to use the new toolbox. I know there’s an argument that funds may be using derivatives to create a simple and safe product. But I think the industry should grapple with this itself, as sorting out classifications would engender trust among retail investors.
IndexUniverse.eu: What’s your opinion of exchange-traded funds?
Mackay: I like ETFs, and you can’t deny their convenience for gaining exposure to particular markets at a particular price. A few years ago I was asked regularly at industry conferences about the competitive challenge from exchange-traded funds and I used to say that they might grow to 10-15 percent of the overall funds business, at most. Now I think they may get to be much bigger than that.
More broadly, our surveys of fund selectors tell us that investors are primarily concerned with getting value for money from their asset managers. Those fund groups that offer this, whether via index trackers or active products, will do well.