The lure for advisers to use discretionary fund management (DFM) services is a clear one. In an age where the wider responsibilities of financial planning, customer communication and regulation take up more and more time, outsourcing investment management to a third party is an understandable decision. The specialised expertise provided by a DFM also lends itself well to a focus on client outcomes.
Traditionally, outsourcing was implemented through a bespoke mandate agreed between DFM and adviser, or via an off-the-shelf managed portfolio service (MPS). Lately, however, it is a new variant – a model portfolio service accessed through an adviser platform – that has attracted the most interest from intermediaries.
Chart 1 shows that most DFM launches have focused on this area in recent years, although the slowing pace of growth also indicates that most providers now have their propositions in place.
On-platform MPS typically have lower costs, lower minimum investment levels, and their structure can ease adviser worries about a DFM eventually taking over the client relationship.
But there remain a number of bugbears that have yet to be fully eradicated by DFMs. Chief among these are charges: DFMs charge less via platforms because administrative duties are done for them, but advisers still have to add on the platform’s own charges as well as underlying fund costs.
As a result, advisers remain divided on the benefits. Dean Mullaly, managing director of Mark Dean Wealth Management, says: “I really don’t get why an IFA would hand over full control of the asset allocation and fund picking to a DFM, and lump the client with the additional cost burden?”
“Both [DFMs and platforms] are of more benefit to the adviser than the client in many situations,” Mr Mullaly says.
However, Lee Hartley, CEO of advice firm Fairstone Group, disagrees. Mr Hartley says DFMs provide an important function in order to free up time for advisers. “It removes any conflict of interest when advisers are forced to justify their own performance where they are running the portfolio themselves,” he adds.
Making the switch
Recent evidence suggests that advisers are increasingly favouring Mr Harley’s argument. In December 2016, support services company Threesixty surveyed 144 advisers and discovered that 87 per cent use DFMs; an increase of 9 per cent from the previous year. Data from Schroders’ annual adviser survey, also released in December, tallies with this, albeit less emphatically. It found the number of advisers who outsource had risen above 50 per cent for the first time in the survey’s history.
James Goward, head of sales support at Rathbones, says last year’s EU referendum result provided advisers with a new reason to outsource. “I got a sense that some advisers got to a point where they were raising the investment white flag around some of this. Their clients were probably expecting them to do something with their assets, but were quite unsure about which way to go with it,” Mr Goward explains.
The picture is not clear cut though. Even those favouring DFMs often still use more traditional methods for part of their client base despite the growing availability of discretionary solutions for smaller clients.
Mr Hartley says: “Around 30 per cent of new business by value is outsourced to DFMs – these clients tend to have larger sums to invest. Clients with smaller portfolios (under £100k) tend to be directed towards a unitised solution (multi-asset funds). Advisers use the annual review process to look critically at relative performance on behalf of the client to ensure progress is on track.”
Whatever the option, remaining aware of the risk of shoehorning clients into a single solution is paramount. Suitability remains the responsibility of the adviser when it comes to most DFM services, and the FCA has increased the focus on centralised investment propositions that may adopt a one-size-fits-all approach with little thought to individual customer needs.
Is it worth it?
Like it or not, the issue of cost has been a dominant and recurring theme in the industry, with justifications for and transparency of charges placed firmly under the regulatory spotlight for many years.
The Retail Distribution Review (RDR) made solid ground in addressing upfront adviser charges despite the recent emergence of a fresh debate regarding flat versus percentage-based fees.
Of late, scrutiny has switched to the asset management industry, particularly when a regulatory review towards the end of 2016 identified the need for a shake-up. This could yet have repercussions for advisers and DFMs, and at the very least it ensures the topic is not fading away.
“There will be an increasing focus on cost,” says Mike Barrett, consulting director at the lang cat, although he adds it is business as usual for now. “That is only an interim study and as much as it’s potentially hard-hitting there is no change to legislation at the moment.”
As more and more assets move to platforms, which take care of administrative issues themselves, costs are likely to move up advisers’ agenda when it comes to dealing with DFMs.
Research carried out by the lang cat in 2016 entitled: Never mind the quality, feel the width 2 analysed and compared costs in the multi-manager and DFM spaces.
It found that the mean average ongoing charges figure (OCF) for multi-manager/multi-asset (MM/MA) funds is 1.01 per cent, with DFMs charging less at 0.79 per cent. Indeed, 53 DFM portfolios have a lower OCF than the lowest MM/MA fund – on the surface at least. In the case of on-platform portfolios, DFMs typically charge between 0.25 per cent and 0.50 per cent (plus VAT).
But what effect does this have on performance? Table 1, which compares the average performance for DFMs compared with MM/MA funds, shows there is little to choose between the two on this front.
When considering average growth over the 10 periods surveyed, each method has taken a share of the spoils by outperforming the other on five occasions. Both have struggled to outperform the FTSE 100 on a number of rolling three-year periods – understandable, in many cases, given that equities have been in a bull market and DFM and MM products are designed to be run for a given level of risk.
For similar reasons, the proportion of portfolios outperforming is relatively low. But this comparison does at least indicate that DFM offerings have been more likely to outperform their multi-manager peers. Whether that is achieved by simply by taking more risk is unable to be assessed from this set of data.
The selection process
Given the complexity of the market, selecting the correct DFM for an individual client’s needs is no easy task. Mr Hartley’s firm has a panel of 10 to choose from and explains the necessary steps to ensuring they are fit for purpose.
He says: “We conduct central research on the DFMs and run quarterly comparisons between the DFMs to ensure they don’t fall behind their peers. This research is distributed to all advisers each quarter to assist with their selection.”
Using a panel of DFMs is widely perceived to be the best way to outsource investment responsibilities. But it appears the proportion of advisers using a broad range of DFMs may be smaller than many assume.
In April 2016, a survey by FE found that more than half of advisers used a single DFM portfolio, with 35 per cent using between two and four, and only 13 per cent having a panel more than five providers.
Advisers cited concerns around the opaque nature of model portfolios, making performance comparisons difficult and time-consuming. Greater transparency around returns, as well as costs, is another issue that may feel DFMs should be doing more to address.
Mr Goward says that even providers are not particularly comfortable being the sole proposition and feels the regulator is in favour of a wider offering. “You need a panel of DFMs that have a slightly different approach. Some of the work over the past two to three years we’ve been doing is to better articulate our proposition so an adviser knows the role that we can perform for them,” he explains.
Regulation
The regulator’s keen eye on the DFM market has not been confined to cost alone. In January, the FCA announced that providers should be on guard from scammers who use DFMs to add an additional layer of opacity to their offering. It said “increasingly sophisticated” scams can involve the creation of a DFM portfolio. This portfolio may invest in the bonds of a special purpose vehicle, which was itself only established to buy unregulated assets.
As this implies, it is vital that advisers do all they can to assess the quality of the underlying assets in a DFM portfolio when they conduct their due diligence. The regulator has removed the permissions of a handful of DFM businesses in recent years because of investments such as mini-bonds and other esoteric assets.
Suitability extends beyond just the investigation of non-standard assets – it is also a question of ensuring that DFM risk profiles are doing what they say they do.
Mr Mullaly suggests that platform technology must evolve to enable automatic trading when certain parameters are hit to ensure a consistent risk profile. But for now, the responsibility lies firmly with the adviser.
Looking ahead, it is too soon to say whether the rise of outsourcing has peaked. There has been a small, but notable trend for some larger adviser firms to seek discretionary permissions themselves, as Mr Barrett of the lang cat notes. He explains that increased operational efficiencies have been a key driver of this pattern.
However, although managing client money in this way should be “breathtakingly easy” for advisers once discretionary permissions are in place, the complexities involved mean reaching this point may take some time.
“It’s not going to be an overnight job,” Mr Barrett concludes.
