At present, many are building advisory portfolios to match an asset allocation, either through a fund supermarket or perhaps a wrap platform. The asset allocation is often built to the output of the adviser firm’s chosen risk profiling tool and such a process introduces a consistent and repeatable process into an adviser firm’s overall proposition. However, internally it requires a level of cost and administration as there must be communication with each underlying client before a fund switch, for example, can be implemented.
If reducing internal costs and improving overall efficiencies are part of an adviser firm’s strategic direction then utilising the services of a DFM to manage the investments within a centralised investment proposition becomes an option worth considering. The FSA published a draft guidance consultation paper, GC12/06, Assessing suitability: Replacement Business and Centralised Investment Propositions, earlier this year, which focuses on the advisory process to recommend discretionary investment management accessed through a CIP. This has thrown up various areas that the regulator believes financial planning firms should take into consideration.
Having made the decision to explore the idea of using a DFM, what are the main factors that adviser firms should bear in mind when carrying out their own due diligence on which DFMs might be most suitable to manage the investments in a CIP or be included on a panel?
The first thing to be determined is to confirm exactly what the financial adviser firm’s overall philosophy and proposition is going to entail; will it need to change with the onset of RDR or can it remain as it is? Once the strategic direction of the firm has been decided, then identifying potential DFMs with the particular expertise the adviser firm is looking for becomes a lot easier, though it will still take time and effort.
The FSA’s draft guidance paper makes the point that when advisers recommend a CIP managed by a DFM, they should ensure that the CIP does indeed meet the needs of the client. The CIP cannot be seen as a one-size-fits-all solution but should only be recommended if in the client’s best interests. Advisers are best-placed to establish this as they understand the client’s long-term objectives and current financial situation having carried out a detailed risk-profiling exercise.
The FSA highlight in their paper that there is a danger that a CIP being offered may not align clearly with the definitions of risk and outputs from the adviser firm’s risk-profiling process. This means that there is a potential disconnect or mis-alignment. It also raises the question of whether a DFM’s range of pre-built model portfolios will be appropriate for the underlying clients of that particular adviser firm.That decision will ultimately be the advisers’ but it does introduce some subjectivity. For example, an adviser firm may well have a strong philosophy of their own regarding implementation of an asset allocation strategy and only wants it to be achieved via an index-based approach in order to control costs and mitigate manager risk. Taking that example further, if the adviser firm have taken a view that they would prefer for their clients to only have exposure to asset-backed ETFs could they use the model portfolios of a DFM who allows exposure to swap-based ETFs? This is why it is crucial for the adviser firm to have confirmed their proposition before engaging with potential DFMs.
To ensure that any CIP run by a DFM is going to be in line with their own firm’s proposition and philosophy, advisers will increasingly be looking for DFMs who have the flexibility and breadth to build investment solutions right across the investment spectrum, ranging from index-based portfolios through to “core-satellite” blended portfolios of index and active funds, as well as portfolios of directly held securities. The term “portfolio architect” becomes more pertinent to describe the DFM, as future conversations with financial advisers in a post-RDR world are more likely to be along the lines of “what solution would you like us to build for your firm” rather than the current “this is what we offer”.
This being the case, the breadth of the DFM’s experience and depth of expertise become important factors for the adviser firm. This is because the remits from adviser firms will differ: one might be looking for expertise in income generation, another for expertise in direct equity investment and another for expertise in building index-based asset allocation strategies through a wrap platform. In order to cater for different demands this requires a breadth of knowledge, coupled with the ability to build bespoke solutions for adviser firms underpinned by an investment process.
Linked also to the question of experience is durability. Longevity and experience will be very reassuring for an adviser firm trying to establish who they might want to consider working with. The first port-of-call or filter might well be a due diligence questionnaire answered by the DFM but this should always be backed up with onsite due diligence in order to gauge resources and capabilities
One major question for advisers is how best to engage with their chosen DFMsOne major question for advisers is how best to engage with their chosen DFMs. Many adviser firms have one or two wrap platforms at the heart of their proposition and so may insist on engaging with prospective DFMs through their chosen platform.
However, this is not always the case, nor, indeed, always appropriate. DFMs who cannot engage in this way may find themselves at a disadvantage as the wrap platform is a powerful tool for adviser firms, addressing as it does the issue of custody of assets and transparency of process. Working on a direct basis with a DFM means that the DFM is likely to have custody, begging the question in the adviser’s mind of what happens if they choose to no longer work with the DFM? Engaging with a DFM through wrap platform, however, does this mean this potential problem diminishes as custody of the assets will be through the wrap platform, thus enabling the adviser firm to simply appoint another DFM to manage the assets should the relationship with their existing DFM come to an end.
Another factor when assessing a CIP run by a DFM is evidence of a rigorous and consistent investment process. This necessitates looking at the DFM’s infrastructure overall and then drilling down to the level of who will be managing the portfolios, what is their fund selection process, and how are decisions made and evidenced to switch funds. Process leads into a discussion about cost, one of the main factors raised in the recent draft guidance paper, particularly in relation to recommending a switch into a CIP managed by a DFM.
If the adviser firm sees value in the fund selection and monitoring being done full-time by a specialist DFM who by virtue of their size has access to the fund managers in the industry, then that is a sensible reason to consider using them. Added to that, it might also be that the efficiencies in portfolio management that a DFM can bring also have value for the adviser firm; for example, a DFM can rebalance an asset allocation, or carry out a fund switch, without having to contact the client first of all. Not only does this mean fund switches can be carried out for all clients at the same time (a repeatable, consistent process) but it also means that the adviser firm avoids having a lot of slightly different variants which can be the case when running advisory portfolios. In their paper the FSA warn about avoiding portfolio drift and an efficient rebalancing policy implemented by the DFM mitigates against this risk, ensuring the risk profile of the client and the risk profile of the portfolio do not move out of alignment.
In conclusion, the question for an adviser firm looking to integrate a DFM into their proposition is a simple one: will the cost of the DFM deliver value to my proposition and, by extension, to my underlying clients.
Mike Mount is head of Cardiff office of JM Finn & Co
