Broker funds get the watchdog treatment

Independent financial advisers face stringent new rules on certain products, writes James Moore.

Barely a week passes without City investment watchdogs cracking down on another alleged financial scam. The most recent example concerns so-called "broker funds", a special type of investment that has vacuumed up almost pounds 2bn from more than 130,000 savers.

Just over a week ago, the Personal Investment Authority (PIA), the frontline financial regulator, announced a package of new rules aimed at tightening up the rules on broker funds. It is also setting up a monitoring unit to keep a close watch on them, and on the activities of those who sell them.

The PIA's intervention, several months behind schedule, follows a survey it carried out suggesting that investors who place their money in them get a poor deal.

Broker funds are set up by firms of independent financial advisors (IFAs) and managed by life insurance companies or unit-trust managers.

The fund management company provides the IFA with its "own" fund, the broker fund which can even be in that IFA's name. It holds the assets but the IFA tells the company how the cash should be invested.

These schemes have caused controversy, first because the supposedly independent IFA firm is recommending that its clients invest in a product it has a direct interest in, and second because with both life company and IFA taking a cut, the schemes can be expensive.

The IFA will typically receive a slice of initial commission between 3 and 6 per cent for placing the money in a broker fund. The management company may then charge up to 1.5 per cent a year for looking after the money, while the IFA creams a further 1 to 1.5 per cent for its fund-management "expertise". In effect, a broker fund may need to achieve annual returns of at least 5 per cent just to stand still against inflation.

The PIA has taken action as a result of a report it published 12 months ago which compared broker funds against similar funds run by life and unit-trust companies.

The report says: "The performance figures from 1 January, 1990 to 4 November, 1996 show that whilst life funds grew by an average 7.3 per cent per annum compound during this period, the equivalent life broker fund grew by 6.1 per cent per annum. Whilst the average pension fund grew by 9.2 per cent per annum over the period, the equivalent broker fund increased by 7 per cent per annum."

The PIA blames the poor performance on "the additional management fee withdrawn from the funds".

The PIA is now demanding that IFAs acting as broker-fund managers incorporate a "conflict of interest statement", with letters to clients explaining why they have recommended a particular product.

These letters will also have to explain why the fund is suitable for an investor compared with similar non-broker funds, what the options are to switch out of the funds and what this will cost.

Significantly, the letters will have to contain a periodic statement of the fund's performance and if the fund is not performing as well as its benchmark or index it will have to explain fully and clearly why.

Broker-fund managers will have to take specialist exams to run them, and annual letters sent to investors to explain why a broker fund remains suitable for them should explain why a fund has under-performed its target benchmark, if this is so.

IFAs are only allowed to recommend broker funds if there is no generally available product that would better suit a client's needs. But the PIA has dropped proposals to ban them from recommending broker funds if there is already a generally available product that would meet a client's needs as well as a broker fund - the "better than best" test.

Paul Hatch, director of the National Association of Broker Fund and Investment Managers, says he is pleased that the rules, due to be out in September, have been published. "It is positive they have come forward with a response, which is long overdue. Now we know the PIA is not trying to kill broker funds off we can move forward."

Mr Hatch maintains that broker funds can survive and are a useful product for investors.

His view is echoed by Philip Warland, director-general of the Association of Unit Trusts and Investment Funds (Autif).

Autif questions the validity of comparing broker funds' performance with similar non-broker funds. It says that broker funds tend to perform better when markets are falling and the PIA's figures do not pick this up.

Mr Warland says: "It should be down to the consumer to decide what is good value for money. A lot of clients will pay a bit more because they trust the manager and are happy to deal with him."

But despite these arguments, and the new rules, broker funds sill have critics.

Hargreaves Lansdown Asset Management, a very large IFA firm, runs an offshore broker fund, a niche product, with a team of four specialists. Peter Hargreaves, the managing director, says that "99.9 per cent of the market doesn't have enough experience to manage them in my opinion".

"In general there are lots of problems with them, especially if they invest in other people's funds. I don't believe that if there is double charging it can be good value," he said.

Gareth Marr, chief executive of IFA firm MMB, said bluntly: "As an IFA you should only put a client into an investment if you are willing to take them out again. I suspect many independent financial advisers who do broker funds are not so active in advising clients when to go out as they are when to go in."

How broker funds compare

1 year % 3 years % 5 years %

Broker life

fund: 3.63 23.81 35.49

Non-broker

life fund: 5.38 32.48 49.04

Broker pension

fund: 5.76 31.72 45.3

Non-broker

pension fund: 7.84 41.18 62.5

Sector average percentage change over one, three and five years to March 1998 (offer to bid, income reinvested) Source: Micropal.