Beware of the rules around DFM

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Rathbones
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Supported by
Rathbones
Beware of the rules around DFM

Regulation has undoubtedly had a major effect on advisers’ working lives, but their relationships with third parties have also been shaped by both the introduction of new rules and the evolution of existing ones.

Discretionary fund managers (DFMs) are one group where this has been particularly obvious.

Many DFMs prospered on the back of 2013’s RDR rules, which led many advisers to outsource their investment responsibilities.

But several years later, heightened levels of regulation have exposed complications in the partnership between an adviser and DFM.

Under Mifid II, intermediaries must provide their clients with annual cost and charges reports

Mifid II, which came into force at the start of 2018, placed many fresh reporting requirements on intermediaries.

These, for one, have raised questions about the extent to which advisers use DFMs.

Under Mifid II, intermediaries must provide their clients with annual cost and charges reports, outlining how investment returns have been affected by fees and other costs.

For some advisers, these reports have made it difficult for them to justify DFM fees to clients, meaning more assets could be run in-house in future.

On the other hand, the FCA’s Prod requirements, introduced alongside Mifid II rules, require advisers to segment clients by their needs.

Additional burdens and complications such as these could convince more advisers to use DFMs.

For those who do use DFMs, today’s regulatory environment can create confusion about how this partnership works.

One notable example concerns the Mifid II rule that clients must be informed within 24 hours if the overall value of their portfolio has fallen by 10 per cent or more in a reporting period.

This applies to portfolios run on a discretionary basis, either by advisers themselves or those outsourced to a DFM.

In the latter case, there can be confusion about who informs the client.

If advisers are operating under an “agent as client” agreement, serving as the DFM’s client on behalf of the end investor, some have argued that only the adviser needs to be informed.

However, if the end client has been “introduced” to a DFM by the adviser, clarification is needed on whether the DFM should directly contact them or simply inform the adviser.

This is further complicated when portfolios are held on platforms, which may have the information required. As such, advisers need to clarify how the process works.

Other less obvious issues have emerged around how a DFM is appointed.

If you have signed an intermediary agreement with a DFM, based on the agent as client rule, but have not read and understood the terms and checked your client agreements meet with the requirements, you may have inadvertently left yourself vulnerable to future claims PFS

As noted, an adviser can work under an agent as client arrangement, essentially dealing with the DFM on behalf of the end investor.

But the Personal Finance Society (PFS) warns that some intermediaries believe they are operating under such arrangements without in fact having the correct level of authorisation.

In a paper released earlier this year, “Agent as client: What you need to know”, the PFS noted that some advisers may have entered such arrangements without proper documents, leaving them vulnerable to legal claims from clients.

“If you have signed an intermediary agreement with a DFM, based on the agent as client rule, but have not read and understood the terms and checked your client agreements meet with the requirements, you may have inadvertently left yourself vulnerable to future claims,” the paper warns.

“If a standard advisory agreement is in place between you and your client, you are unlikely to have such a level of authority and have therefore exceeded your client’s authority.

"As such this may lead to DFMs not being properly appointed by you as you do not have the legal power to do so.”

As such, advisers need to closely analyse the documents clients have signed.

Greg Mullins, director of sales at Rathbone Unit Trust Management, adds: “It is essential that advisers understand the contractual basis on which they are operating and ensure this is right for their client, business model and regulated permissions.

“In general, it has been poorly understood that a contract exists and what the consequences are of different client on-boarding methodologies.”

They should also make sure clients fully understand the agent as client arrangement.

The end client would not be able to take the DFM to the Fos, for example, while advisers have additional fiduciary duties to the end client.

The PFS also notes that under agent as client, the DFM “often has no knowledge of the end investor and there is no direct contractual relationship with the end investor”.

This can potentially make it difficult to meet the Prod requirements of segmenting clients by need.

Agent as client can also affect investment portfolio composition, both positively and negatively.

An adviser can be considered a “professional client” of the DFM, meaning the latter can potentially use more esoteric investments that cannot be promoted to private investors.

As such, under agent as client the portfolio may include investments that could promise good returns but also bring challenges such as liquidity issues.

There are alternatives to agent as client.

As mentioned, an advice firm can arrange for the client to have a direct relationship with the DFM.

Under the FCA’s “Reliance on Others” rules the adviser and DFM share a regulatory duty of care to the end client. The end client can also take the DFM to the Fos in the event of a grievance.

As FCA rules, Mifid II obligations and other regulatory requirements continue to evolve, the relationship between an adviser and DFM will only incur greater complications. As such, education and due diligence on the part of the adviser is as important as it has ever been.