DFM survey: A watershed moment

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DFM survey: A watershed moment

It’s no secret that discretionary fund managers (DFMs) have benefited handsomely from regulatory changes in recent years. The RDR rules, introduced in 2013, effectively led many intermediaries to outsource their investment responsibilities, allowing DFMs to amass significant assets.

Several years on and the sector has kept up momentum, with Money Management’s latest survey of the industry showing DFM assets have continued to rise in the past year. But suspicions of a plateau in industry growth refuse to go away. At the same time, the space faces its biggest moment of uncertainty since RDR implementation, again due to regulatory change.

Mifid II regulations, which came into force in January this year, have already caused major disruption for advisers, wealth managers and fund firms alike. Businesses must now illustrate costs and charges more clearly to clients, and other requirements – such as the need to inform clients of every 10 per cent drop in their portfolios – have led to a clarification of reporting lines.

The true impact of the rules will become clearer in the wake of implementation. With Mifid II-induced transparency improvements spurring greater competition, DFMs now expect to face a “watershed” moment. But they are also optimistic that the regulation will prompt those advisers that run money in-house to reassess this approach.

Letting the light in?

This year’s survey captures a broad swathe of the industry, with the biggest names again taking part and some smaller firms included for the first time. In total, 27 DFMs responded this year, up from 21 last year. JM Finn was not able to submit a response this time around, but new entrants include Gam, Parmenion and Waverton.

Many respondents cited regulatory changes as the main challenge they face. But some, such as Quilter Cheviot, believe the new rules will prove a positive turning point for investors and providers alike.

“Far from being yet another regulatory burden to be endured by us all, Mifid II could in fact turn out to be a watershed piece of regulation that helps asset managers, financial advisers and their clients alike to hold informed, considered conversations about the cost and value of investment solutions,” the firm notes.

It adds that greater cost and charges transparency “should make for the possibility of more realistic comparisons between the cost of a DFM service and that offered by multi-manager or single-strategy fund providers”.

An increased focus on cost is likely to increase the scrutiny on discretionaries and their competitors. Intermediaries who outsource, whether via a DFM or multi-asset funds, are more likely to find clients asking difficult questions of charging structures now that these are being presented more comprehensively pre- and post-sale.

There are already signs that fee pressures are feeding through into the DFM space this year. Whitechurch, one of the survey’s smallest participants in terms of assets, cut its model portfolio service (MPS) management charges from 0.35 per cent to 0.1 per cent earlier this year. 

In the company’s financial results for the year to 28 February 2018, director Robert Dyte said: “Over the past 12 months there has been a continued drive to gain third-party adviser business into the discretionary management service, but net flows have come under pressure from aggressive price competition in the industry.”

Any effects of Mifid II and fee competition should be visible in discretionary charging structures. However, widespread changes are yet to emerge. Table 2, which outlines DFMs’ fees, has changed very little from its 2017 counterpart.

As in last year’s survey, charging structures remain disparate and at times convoluted. In the case of many bespoke offerings, a tiered structure is used. MPS charges are simpler, and roughly the same as in 2017. Many MPS offerings based on buying active funds charge between 0.25 and 0.35 per cent at a headline level.

Additional fees, such as transaction charges, also apply for those using certain providers. Again, many of these have not changed from the previous year, though Quilter Cheviot argues they could fall victim to post-Mifid scrutiny. “We believe Mifid II has already forced DFMs to begin to phase out, or at least be forced to reconsider, having charging structures that include transactional charging,” the firm notes.

Tilney says it is seeing an increased number of advisers outsource, particularly in the model portfolio space.

“One of the main reasons is the requirement for a presale cost and charges disclosure illustration,” the firm says. “This has meant that advisers are struggling to justify some of the providers and products they used previously, as charges not previously disclosed now make those recommendations seem very expensive.”

This is not the only change firms could be forced to swallow. Commentators have long complained of the difficulty in comparing the charges, investment approach and returns of different DFMs. But the FCA has recently shown signs of taking an interest in this area.

The interim report from the regulator’s investment platforms market study warned “the risks and expected returns of model portfolios with similar risk labels are unclear”, meaning consumers may have the wrong idea about what to expect.

Providers themselves have had problems. Walker Crips notes: “This is confusing for customers, but also unsatisfying for DFMs, who may find a carefully crafted balanced portfolio’s performance compared to a rival’s higher-octane interpretation of the same title.”

The FCA’s finding applied specifically to model portfolios offered by platforms, but further investigation by the watchdog could easily cast a light on DFM practices.

Taking a look

Another issue making it difficult to compare portfolios with similar risk labels is the lack of consolidated performance data from the sector. Many DFMs tend to disclose core portfolio returns, but consolidating such figures is still a time-consuming task. 

“We would advocate a free-to-use uniform basis by which to present our model portfolios, similar to the service that [data providers] Trustnet and Morningstar provide for funds,” says Walker Crips. We welcome transparency and would like our products to be visible. As it stands, we pay different third-party consolidators varying amounts of money to display their own version of our efforts.”

FE Transmission, which looks to compare MPS data, has now signed up more than 30 DFMs, but the service remains the exception rather than the norm.

This year, our survey includes details of provider performance for the first time. To assess how different propositions fare, we have looked at the five most popular MPS among advisers, according to Defaqto’s 2018 DFM service review, for whom three-year performance information is available. 

Chart 1 details how MPS offerings across the risk scale – as ranked by Distribution Technology – perform. For advisers, the important task here is to ensure that the risk-return equation is correct. In rising markets, the risk-rated portfolios they use should produce larger returns at higher risk levels. 

While only a small snapshot, the chart illustrates that, contrary to some industry concerns, these models have broadly performed as expected. Returns have increased, in a smooth fashion, relative to the risk taken. We hope to expand our coverage of performance figures in future editions of the survey.

Comparing returns – across model portfolios, at least – is easier than it once was, but there is no standard set of timeframes over which providers disclose these figures. Some break returns down into discrete 12-month periods but do not calculate cumulative three-year numbers, while there are still others that are yet to disclose performance numbers at all. As such, a unified form of disclosure remains far off.

Buy lists

Another addition to the survey this year is an investigation of fund buy lists, outlined in Table 4 and Chart 2

Such lists can be similar in terms of their core components, but they vary significantly in size. The largest buy list, run by Cazenove, consists of more than 1,000 funds. Others from the likes of Smith & Williamson, Quilter Cheviot, Investec Wealth, Brewin Dolphin and Brooks Macdonald run into the hundreds.

Certain variants, such as RC Brown’s 23-strong list, are much smaller, while some respondents do not operate formal buy lists.

In an era of growing consolidation, and centralisation, the question of how much freedom investment managers have over their portfolios has also become more relevant. Managers working for around half of respondents can buy funds not included on their company’s panel. But often doing so requires a form of internal approval. 

Brooks Macdonald ensures off-list investments are “monitored and restricted”, while Charles Stanley and Close Brothers only allow such holdings within bespoke portfolios. Cazenove, meanwhile, says these decisions are assessed on a case by case basis.

As Chart 2 shows, a majority of DFMs using buy lists have seen them get bigger in the past three years. Seven have seen such lists expand slightly, with three seeing a more significant increase. Only five have seen their buy lists shrink, while four have witnessed no change.

The factors behind buy-list expansion remain up for debate, though for Wellian it has stemmed from the firm taking on more mandates and thus requiring a greater range of funds.

Intermediaries considering different DFMs should always consider how their buy lists compare, given claims from some quarters that there is a growing homogeneity of selections.

Two years ago, a report from the Lang Cat and CWC Research suggested “very few” DFM portfolios could claim to have unique or individual portfolio holdings. A separate report by consultancy gbi2 and research house Fundscape also highlighted misgivings about these lists, saying some inclusions displayed “less performance substance and more reputational and sales momentum”. 

Gam uses its response to the survey to criticise the similarity of buy lists, adding: “We are not drawn to brand names and invest based on talent, often with lesser-known boutiques.” Similarly, LGT Vestra claims its managers construct portfolios “populated with both familiar names and unique opportunities”.

Concerns over buy lists have risen partly as a result of DFMs gathering significant assets and needing to invest in large funds for liquidity purposes. So one way for smaller DFM firms and advisers to stand out is by choosing lesser-known funds.

In or out

The Mifid II regime increases scrutiny and competition for those operating in the discretionary space, but it also enhances the burden on all companies with investment responsibilities, including intermediaries. As a result, respondents are hoping a fresh surge in the number of advisers outsourcing could yet emerge.

“We do not believe [the outsourcing trend] has yet reached its peak,” says Brooks Macdonald. “The requirements of regulations such as Mifid II are likely to see a rise in the numbers of advisers outsourcing to DFMs, as they will increase the fixed costs involved in the provision of financial advice.”

The asset levels detailed in Table 1 show an ongoing expansion, one that cannot solely be attributed to market movements. But as in last year’s survey, a large chunk of assets sits in the hands of just a few companies. Each of the five biggest names by advised assets – Brewin Dolphin, Brooks Macdonald, Investec Wealth, Rathbones and Quilter Cheviot – has seen an uptick in overall levels from 2017.

The shift upwards in terms of externally advised client assets is notable. Brewin Dolphin has £12bn, up from less than £10bn in 2017. Brooks Macdonald has seen an increase from £6.9bn to £9.5bn. Investec Wealth has £600m more in externally advised assets, with a £1.1bn rise for Quilter Cheviot.

Client numbers have also increased at these firms, with the two exceptions – Brooks Macdonald and Quilter Cheviot – down to the fact that these companies reported the number of client accounts, rather than the number of clients, in last year’s survey.

Perhaps unsurprisingly, respondents also believe the frequently discussed threat of advisers taking investments in-house now looks overstated. This year’s Nucleus Census research agreed that the interest in obtaining discretionary permissions “appears to be waning” among intermediaries. One in five respondents to its 2016 research planned to hold such permissions, but by 2018 this had fallen to less than one in 10.

However, some will always seek to run investments themselves, whether on an advisory or discretionary basis. Although the challenges of Mifid II compliance have been tipped to trigger greater levels of outsourcing, the need to justify charges, among other reasons, will still lead some intermediaries to run money for clients. 

Other recent research suggests outsourcing is not the attraction it once was. Defaqto’s latest DFM service review, carried out among advisers, found the proportion of respondents using advisory portfolios jumped from 24 per cent in 2016 to 38 per cent last year. The overall share taken by discretionary offerings fell from 72 per cent to 59 per cent.

Defaqto suggested the need to justify charges was one potential driver. The research provider also pointed to greater competition from the likes of multi-asset fund providers.

Construction

Our survey also looks at the tools different companies use in their core portfolios. The responses, outlined in Table 3, show that several wealth managers, including 7IM, Brooks Macdonald, Smith & Williamson, Parmenion and Thomas Miller, do not invest directly in individual securities in core portfolios. This stands in contrast with the group of DFMs and multi-asset managers that have adopted direct investing in recent years, in part to reduce costs.

Several respondents do not include investment trusts in core portfolios, which is most likely related to an inability to buy these on many platforms and the difficulties that can arise when buying and selling trust holdings to rebalance portfolios.

As noted in the tables, several DFMs still cater to specialist needs with niche portfolios, including the likes of Aim offerings and other tax-focused services. As Money Management has previously reported this represents a broader shift, with some DFMs increasingly catering to very specific client needs.

Demand here shows little sign of abating. But with Mifid II expected to spur competition in the DFM space as much as anywhere, it is unclear who in the sector will continue to reap the rewards of these investment trends.