Everyone should carefully consider using a discretionary fund manager. These are not the blindly enthusiastic words of a young salesman; I am old enough to be a realist, and nearly old enough to be a cynic, but I truly believe everyone should consider using a DFM and so I often question the reasons I hear for not using one.
The reasons given for not using a DFM are varied; but the two most frequent, and most disappointing are when DFMs are considered an extra layer of cost, or when someone says “I can do it better myself”.
When questions are raised about cost, it is usually because the value has not been recognised, and when someone says they can do better I believe it is because the industry’s measure of success is not the same as a client’s measure of success.
I believe both reasons for not using a DFM to be currently valid, and the reason those queries keep emerging is because they have not been addressed properly – the industry is not dynamic enough.
Funds and model portfolios are products; they are run to a mandate that does not consider the objectives, financial circumstances, attitude to risk and investment time horizon of the individual investors. The standard methods used to benchmark performance and risks are valid because the clients invest with the knowledge that it is a ‘best fit’ scenario not a bespoke solution.
But I am talking about DFMs, and I believe that is a very different offering. It is a personal investment service. A DFM is supposed to take into account the full picture, and create something for that individual client, that means standardised measures of performance and risk, for example, indices and volatility, while useful, should not exert as much influence as they do on portfolio management, instead the biggest influence on portfolio management should be the clients’ objectives.
Another statement I have made before is that no client has stated that his objective is “to outperform a balanced index net of costs over five to seven years”. Granted, some clients may not know what is achievable, but I would venture a large number will have an outcome in mind. It might be to achieve an income sufficient for a comfortable retirement. Perhaps the client wants to generate a lump sum large enough to pay their children’s university fees. If we do not focus on the client’s objectives, how will we ever demonstrate that we are adding value?
This brings me to bespoke portfolios, which I believe is the key of the added value delivered by a DFM, but what does it mean and what should it be? Bespoke should mean the portfolio is designed to meet the client’s specific objectives, and that cannot be achieved by some minor changes to the underlying holdings.
It is universally accepted that asset allocation has the greatest influence on investment returns, some studies suggest up to 90 per cent. So I feel it is safe to argue that, if you are creating a bespoke portfolio that focuses on a client’s objectives it is the changes you make to the asset allocation that should make it bespoke, not the debate over the client preference for BP over Shell.
Being constructive
So, having made a number of statements to criticise the industry that pays my wages I should probably try to make some constructive suggestions on how it could function more appropriately.
1. Achieving the client’s objectives is our job; no client has ever asked to outperform a balanced index net of costs. The industry needs to begin to listen more carefully to clients, we need to understand their objectives, and then work to achieve them, and reporting against them.
2. For a DFM the clients objectives have to be the most important benchmark, make a client happy and you have done a great job.
3. We must recognise that a time horizon is not a suggested period for holding the portfolio, as is often the case with fund investments, but a period of time over which the client requires the portfolio to be managed, and with that we should adapt the strategy to suit a cautious investor with three years before he needs the money is very different to a cautious investor who is investing for 10 years.
4. The industry has an enormous focus on risk, but all too frequently the word risk simply means volatility.
If your clients have different investment objectives and time horizons it is reasonable to assume they will have different perceptions of risk.
There are an abundance of quotes and references about client’s aversion to risk, followers of behavioural finance will regularly point to prospect theory and the statement that clients dislike losing money more than they like making money and it seems no presentation is complete without reference to Warren Buffet.
No one likes losing money, but volatility and losing money are not the same thing. Mr Buffet’s two rules on investing are not a) focus on the short term b) panic when there is volatility.
The world’s greatest investor is a long-term investor, who takes the time to thoroughly understand the fundamental reasons behind each investment decision, and sometimes, particularly over the short term those investments will be ‘losing money’.
Short-term investors have no ability to use risk to their advantage; the laws of probability are stacked against them as short-term investment is speculation so a focus on controlling volatility is wise, but a long-term investor has the ability to absorb volatility and the ‘risk on’ trade can reward. .
There is a line of thinking that equities are in fact a low-risk asset class over the long term, if you fundamentally believe that economies will grow in the long term, then why would you invest in anything other than equities?
Given the volatility in the market over the last 10 to 15 years you might disagree, but numbers for Q2, 2014 (put forward by the asset risk consultant PCI) support my view; over five and 10 years, higher risk (volatility) has paid off, maybe not on a risk (volatility) adjusted basis but certainly in absolute terms, the differential between cautious and equity risk being 50 per cent.
5. So, how does a firm keep control over its own risk if the uniformity we have come to rely on is removed, and how does a financial adviser monitor the DFM it has appointed to manage its client’s wealth? If you wait till the end of the investment term it might be too late.
You create a framework to asses bespoke goals, you use an investment policy statement:
• Use multiple benchmarks for performance monitoring.
• Change the risks you monitor when the risks change – long-term investment volatility can be discounted, to a greater or lesser extent, but as you get closer to a client’s objectives there may be a reason for more focus on that risk.
• Do not fear short-term underperformance.
6. Clear and relevant communication and reporting against a client’s goals is essential.
An investment manager who understands his clients, creates bespoke solutions and reacts dynamically to changes in client circumstances is incredibly valuable and every adviser and investor should consider using one.
With over 200 firms competing in the same space we all need to develop our unique selling point.
Matt Lonsdale is head of intermediary business development of Thomas Miller Investment
Key Points
* The two most common reasons for not using a DFM are: a) they are an extra layer of cost, and b) people believe they can do it better themselves.
* A DFM is supposed to take into account the full picture, and create something for the individual client.
* There is a line of thinking that equities are in fact a low-risk asset class over the long term.
