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Barriers to entry in the investment industry impact on fund performance

28 June 2010 Marriott Asset Management
Dr Simon Pearse, CEO of Marriott Asset Management

Dr Simon Pearse, CEO of Marriott Asset Management

Dr Simon Pearse, CEO of Marriott Asset Management, makes an observation on the investment industry

Barriers to entry are the source of an industry or business’s pricing power - the ability to raise prices without losing customers. The primary driver is to restrict competition in a market. The investment industry, like any other industry, has created and maintained “barriers to entry”. These are apparent in many forms; some beneficial to the investor and others potentially not.

Regulation requiring licenses and levels of qualification from industry participants like asset managers and financial advisors is clearly in the best interests of the investor. One may question, however, the current practice of largely removing front end fees or initial charges and escalating the on-going service fees through performance based fees and layering of structures. The effect of this practice is to link profitability exclusively to assets under management. As a result, it is very difficult for a new player to enter the industry as the break-even point for an asset manager is now about R1bn and for a financial advisor about R100 million. Aside from established financial advisors who have in recent years bundled their clients’ assets up in a fund of funds structure under the “white labeling” banner, there are few new entrants to the asset management industry. It is also interesting to note how few young financial advisors there are in the industry. Gathering 100 clients in order to make a living is prohibitive.

Another interesting barrier to entry seems to be created complexity. Investment management, like so many disciplines, is shrouded in complexity, and kept that way for so many expedient reasons. Consider the unnecessary complexity that is paraded on a daily basis in public forums. Even more so is the observable fact that so many people pore over various media articles seemingly in search of the next extraordinary return or maybe the answer to that interminable anxiety; “is my money safe?”

There are now more than 900 unit trusts on offer, most of them endeavouring to outperform their peers in order to attract new subscriptions. This process is largely endorsed by industry commentators and analysts who tend to promote past returns as the best indication of future returns. So much of the analysis and commentary focuses on short-term returns. In many instances, this has a direct influence on fund manager behaviour. The result is pressure on fund managers to take unnecessary risk and to focus on short term success. This behavior is generally not beneficial to investors.

Of interest, “barriers to entry” is an important driver when selecting investments. The most reliable income streams are invariably found in industries that have high barriers to entry and therefore a few powerful players. Think of the food industry in South Africa; the power lies with a handful of producers and retailers who ultimately determine the price farmers receive for their produce and the price we pay for that produce. You can be sure that an investment in this industry will serve you well over time.

When considering the pharmaceutical, energy, alcohol, tobacco, financial, insurance and telecommunication industries, you will generally find a few powerful players controlling markets and pricing, as well as restricting new entrants. As a result they are generally able to offer investors reliable and growing dividends, a key prerequisite to low risk security selection. British American Tobacco, the largest company listed on the South African Stock Exchange, has grown its dividends every year for the past decade, unaffected by the global financial crisis. 40% of its market is China and the ban on cigarette advertising gives its brands absolute protection from new entrants.

Fund performance describes the fund return commensurate with a level of risk or volatility of that return. It is important to note that the investor’s return is invariably different to the reported fund return. This usually relates to fees paid by the investor and the point in time that the investment was made. The greater and more layered the ongoing fees, the greater the disparity between fund and investor experience. The focus on historic returns and the implicit extrapolation of these returns into the future invariably causes the investor to choose a point in time that is less than appropriate, again creating disparity between fund and investor experience.

Barriers to entry will always exist and can have a positive or negative impact on fund performance and more importantly, the investor experience. “Income Focused Investing”, the Marriott investment style, is the driver behind investment decisions, both locally and internationally. The search for reliable and, ideally, growing income streams, purchased at appropriate prices is the foundation of our business. This approach or style, we find, sits comfortably with investors and tends to reduce a complex world of terms and verbal smokescreens to a simple and intuitive modus operandi.

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