The additional costs to customers of discretionary fund management (DFM) portfolios created by capital gains tax (CGT) and VAT must be important considerations for financial advisers when comparing these portfolios to other solutions such as multi-manager funds or risk-targeting funds.
These additional charges associated with DFM portfolios make it very difficult for financial advisers to carry out accurate cost comparisons, in line with the guidance provided by the FSA in its recent consultation paper on assessing the suitability of investments when outsourcing.
The paper states: “Tax acts as an additional cost by reducing the client’s return on their investment. Firms recommending a replacement investment should consider whether that investment is the most tax efficient option in light of the client’s financial situation, needs and objectives, and also must consider any tax implications of switching.”
DFM portfolios will create a potential CGT liability for the investor every time a trade is executed, even in the case of simple rebalancing, which may happen in isolation of an investor’s individual tax situation. The adviser and the customer have the responsibility for ensuring these ongoing events are recorded on self assessment forms each year.
In addition, the European Court of Justice has recently recommended that all elements of discretionary management services, including dealing fees and commission, should be subject to VAT, which could see HMRC reassess its VAT treatment of DFM services.
The opaque nature of dealing fees and commission within DFM services was also raised as an issue by the FSA suitability paper. In the section about ‘considering costs’ the FSA paper highlights an example of poor practice where a firm offered an external DFM service but “its replacement business cost comparison did not assess the overall impact of all the charges. Although it highlighted that additional charges were levied as a result of trades, it did not pay due regard to the typical volume of trades that may be expected within each portfolio, and hence what the typical overall costs would be”.
Multi-manager funds, including increasingly popular risk targeted funds, avoid these additional costs because all trades take place within the unit trust or Oeic structure. There is no VAT liability and the only CGT liability created is when the fund is sold by the investor, rather than having to deal with multiple potential CGT events throughout the lifecycle of the investment.
DFM services or model portfolios are not bad. They can be a good investment solution for some investors but care must be taken when using them.
The problem with off-the-shelf DFM model portfolios is that if there is no contract in place between the DFM firm and the client and the portfolios are being run with no regard to the personal tax affairs of the investor.
DFM services are traditionally offered to higher net-worth investors who are potentially utilising their annual CGT allowance elsewhere, hence any further CGT event within the DFM portfolio is likely to be a very real cost to the investor.
Thanks to the recent ruling on VAT, a scenario now exists where investors are not going to benefit from simple techniques such as rebalancing because the tax and cost implications may deter the DFM from doing this. This could be to the detriment of the investor.
Ryan Hughes is portfolio manager at Skandia Investment Group
