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At whose discretion

Choosing a discretionary fund manager is far from easy. Fraser Donaldson at Defaqto explains how to carry out due diligence that meets the regulator’s expectations – and suits clients needs.

Suitability lies at the heart of everything that financial advisers do for their clients and selecting a discretionary fund manager (DFM) is no different. Clients’ interests must come first at every step of the process, starting with the rationale for working with a DFM and continuing throughout the due diligence process used to select a particular firm.

As the Financial Conduct Authority (FCA) thematic review in March 2014 (TR14/1 Supervising Retail Advice: Delivering Independent Advice) said: “We expect firms to carry out due diligence on the whole of market to identify the solution(s) that are in the client’s best interests, then conduct detailed due diligence on the recommended solution.” The due diligence process does not stop with the choice of a manager. Both the adviser and the DFM have ongoing obligations, and liability, for ensuring that the recommended investment solution is suitable for the client. The adviser should also set clear key performance indicators, based on client needs and required outcomes, for holding the DFM to account.

The decision to work with a DFM should not be taken lightly. Ideally, it should be a long-term arrangement as, at best, changing discretionary managers is likely to be an administrative headache. Changes may take time, upset the client, mean added costs and, possibly, keep the client out of the market for a significant period. Good due diligence is about getting it right first time. The following will help to develop a robust and repeatable process.

First steps: Pre-due diligence

There is no one-size-fits-all approach when selecting a discretionary manager. It depends on the clients’ needs, the beliefs of their adviser, and type of service required.

Most of the hard work should be done during a client segmentation exercise. This will primarily reveal which segments, if any, are suitable for discretionary management.

It should also give an initial indication on what type of discretionary solution is most suitable. Bespoke or model portfolio? Passive or active investment? These decisions should be based on client needs, ensuring the right balance between risk, cost and complexity.

Once it is clear what type of discretionary solution is required, the next stage is to decide what is expected of the DFM. Most importantly, where does responsibility for suitability lie? 

This will be crucial when determining contractual relationships between the client, adviser and DFM, along with their respective service obligations. Generally, the adviser is responsible for identifying the need for an investment solution, what type of investment solution, an agreed risk profile for the client, associated tax planning and use of appropriate tax wrappers. Some discretionary services offer their own risk profiling and assessment tools arguing that they cannot construct a portfolio for a client without full knowledge of all the client’s circumstances.

Other discretionary managers recognise that some advisers do not want to hand over all the responsibility to the discretionary manager and will insist on leaving the responsibility for suitability with the adviser. Whichever model is used, it is essential that all parties, especially the client, are aware of where responsibilities lie and that unambiguous contracts of service are drawn up.

Key questions 

What steps have you taken to establish the financial strength of the firm? What will your key performance indicators be?

Establishing financial strength is a judgement call but there are some key indicators. If a firm is growing, has a ‘rich’ parent company, is profitable and has significant business coming through the adviser distribution chain then the chances are are that it is well resourced, committed to the adviser market and will be around for some time.

What do you know about the expertise and track record of the management team? Have you met face-to-face?

Due diligence should be used to find out the turnover of key personnel to establish whether there is loyalty, stability and consistency of management. Assess the track record of senior investment professionals to see whether they have produced consistent or volatile performance against the benchmark during the past 10 years. Check whether the analyst team behind investment professionals is well established and resourced. Data can tell you only so much about the culture and commitment of individuals to the firm’s declared investment processes. Meeting management one-to-one is an important way to gain confidence before entering a long-term relationship with a firm.

Do you know what level of service you will receive?

It is important to find out how much face-to-face time you can expect to get with investment managers and account managers based on the firm’s existing client relationships. Can the client or adviser on the client’s behalf call the manager with queries or concerns? This is particularly important for smaller advice firms. The DFM management team should be able to provide regular updates and support that is attuned to the adviser’s needs and works with its existing business processes.

Do you understand the investment philosophy and management approach of the firm?

Why is it appropriate for clients? Firms will use a different philosophy, or blend of them, in their propositions. Here are some key choices to consider. 

Advisers must ensure that the risk taken by portfolio managers matches the risk that the client is willing to take. With a portfolio that is risk-targeted, a priority is to manage volatility within a target range while achieving reasonable returns for the degree of risk undertaken.

Clients may prefer return-focused portfolios, which aim to outperform a stated benchmark during a period of time. Management of risk and volatility would not be a priority, although awareness of risk would be expected.

The adviser must be prepared to monitor these portfolios more closely to ensure that undue risk is not taken.

Bespoke or model portfolios?

Entry requirements and costs tend to rise as a solution becomes tailored to meet an investor’s specific investment needs. Advisers need a clear rationale for choosing a particular investment solution, which can be explained to the client. For example, are model portfolios available on a wide range of wraps and platforms?

Passive or active?

Most DFMs will operate a mix of active and passive investment styles, though some may offer clients and their advisers a wholly passive option.

Risk: the use of passive funds (index trackers) removes stock-specific risk. However, active managers would argue that they have the opportunity to avoid underperforming stocks and markets.

Cost: active investing requires more resources for analysis and research but, arguably, it has the potential to deliver higher returns. However, cost is a drag on performance, so using cheaper passive strategies may appeal more. The ideal approach is to try to find a solution that offers value for money in terms of service quality, rather than thinking about absolute cost.

Complexity: advisers are required to explain to clients why any investment solution is appropriate. A complex solution may make this difficult.

Collectives or direct stocks? 

Most discretionary services will use collectives at some level. However, this is generally more costly than selecting individual stocks and holdings to construct portfolios. Collectives select managers to run specific mandates within the portfolio (multi-manager) and have the benefit of a certain level of built-in diversification.

The key in the due diligence exercise is to be in a position to manage client expectations. Clients would not want to be surprised to find derivatives and alternatives in their portfolio instead of the recognisable shares and collectives they expected to find. 

Have you got adequate information to assess past investment performance?

If clients are looking for a bespoke portfolio then it is difficult to assess past performance as there are no direct comparisons. It may be possible to get an indication of managers’ performance by looking at the aggregate returns of all bespoke portfolios or the DFM firms strategic model. For bespoke portfolios it is important to measure progress against client needs and expected outcomes, rather than a peer group.

Assessing the performance of model portfolios should be easier. But it is important to get a standard format for performance data as this may vary, depending on the delivery date, measure of volatility, whether performance is gross or net of charges, and whether platform charges are included.

How much do you know about the firm’s approach to risk management?

Below are some issues worth examining in detail: Conflicts of interest: are clients introduced by advisers invested in the same way as the firm’s direct clients?

  • Good governance around all areas of the firm: is there an independent, dedicated compliance team?
  • Good strategy for growth: what are the key risks to the firm’s strategy and how are they managed?
  • Competitive pricing: how well is the pricing targeted at the adviser market and balanced with the service provided. Value for money rather than absolute cost?
  • Consistency: does the firm have a track record of sticking to its investment philosophy and management style in good times and bad, without allowing individual managers too much freedom?

Managing risks

When the due diligence process works, DFMs should be able to provide access to some of the best available portfolio management expertise, and allow advisers to reduce their investment risk. This, in turn, gives advisers more time to spend with clients, helping them to achieve their financial planning goals.

When it doesn’t work, a DFM can add cost, complexity and create conflicts over liabilities. With due diligence high on the regulator’s agenda, the benefits of working with a DFM cannot be taken for granted. They have to be researched, documented, tested, reviewed and tested some more. One thing is for sure, choosing to work with a DFM is not necessarily the easy option it at first may appear.