InvestmentsJul 31 2018

Getting a Prod in the right direction

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Getting a Prod in the right direction

Much like their clients, no two adviser firms are alike, and this influences how different intermediaries operate. 

One increasingly prominent element of many advice businesses – the investment committee – is a prime example of this disparity. Advisers’ approaches to clients’ investments are growing increasingly sophisticated. But the committees overseeing these allocation decisions are far from homogeneous.

A paper by ratings firm Square Mile, “Managing an effective investment committee”, suggests some main areas of focus for running a committee, including ensuring suitability, monitoring charges and performance, as well as managing risk.

A committee may take various actions to achieve this according to the paper, as outlined in Box 1. But as Jamie Farquhar, Square Mile’s director of business development, notes, there is “nothing prescriptive” about running such a set-up.

“There are a million ways to skin a cat,” he says. “I think that’s a good thing: we don’t want this to become entirely black and white.”

The parent firms will differ in culture and approach – such as whether they prefer to run money themselves or outsource. Some investment committees will include external figures, while others will not. And investment committees can also vary significantly in what they are responsible for, because other parts of the business may deal with certain tasks instead.

None of this is contentious. But a set of newly introduced rules is likely to force greater uniformity, because they require many firms to check and upgrade their processes or risk the ire of the regulator.

The change has come in the form of the FCA’s Product Intervention and Product Governance sourcebook (Prod) requirements, which the watchdog introduced this year alongside the Mifid II rules. These cover “manufacturers” of products – including the likes of fund providers – but also “distributors” such as advisers.

The requirements, some of which are outlined in Box 2, call on intermediaries to identify the “target market for the respective financial instrument”. In plain English, this means they must make sure that, for example, a selected investment fund is suitable for their client’s needs. This process can consider factors such as how a product fits a client’s needs, risk appetite, the impact of charges on the individual, and even the financial strength of the provider. 

The Prod document calls for detailed information, adding: “The target market identified by distributors for each financial market should be identified at a sufficiently granular level.”

Intermediaries have grown more familiar with the realities of life under Mifid II, including requirements for enhanced levels of disclosure around costs and charges. 

But commentators worry that, more than half a year on from implementation, some firms have failed to fully comply with the Prod requirements. The FCA, which has codified the Mifid requirements, could well crack down on any laggards.

Alarm bells

“There’s a bit of an alarm bell here: if there are rules out there and firms aren’t ready, that’s not the place to be,” says Mike Barrett, consulting director for the Lang Cat. “The fact those requirements are rules rather than good practice means if the regulator wants to do you for something, you are in trouble.”

In the context of an investment committee, meeting the requirements can involve segmenting groups of clients, whether by risk appetite, level of assets or specific needs such as a demand for income, and following a different strategy for each cohort.

This may mean allocating bespoke services to its higher-net-worth clients, with cheaper options for clients at the lower end in terms of assets. Such practices are now widespread, but Mr Barrett notes that they are not yet in place at all businesses.

“One adviser firm I have dealt with is [now] starting to look at its investment process,” he says.

The rules come at a time when both advisers and wealth managers have sought to meet more specific client needs. This includes tax considerations, evidenced by the launch of several inheritance tax and Aim portfolio services in recent years, and a growing focus on ethical investments.

A further source of extra work stems from the pension freedoms and a broader appetite for income.

Considering the decumulation process, and how to manage it, poses a problem for investment committees. One of the issues here, outlined in Table 1, is the risk of a portfolio being hit by a market fall and having to recover its value, which is made worse if a client is taking an income. Other concerns, such as longevity and inflation risk, are also important. The need to cater for clients in decumulation only becomes more pressing because of the Prod rules, and further work may still be required by some intermediaries.

Table 1: ‘Recovering’ decumulation portfolios

Market fall (%)

Recovery required (%)

Recovery required if 5% is withdrawn after the fall

10

11

18

20

25

33

30

43

54

40

67

82

50

100

122

60

150

186

Source: Thesis. Copyright: Money Management

 

“One thing to look at is how an adviser is evolving their committee as related to the pension freedoms,” Mr Barrett says. “It might be established for quite a few years and designed for an accumulation world and client.”

Adapting to this new reality has become a focus for discretionary fund managers (DFMs). One firm, Thesis, sought to tap into this demand last year by launching a decumulation service. More simply, fund firms have also sought to play into this theme by launching multi-asset funds with an income slant, as noted in Money Management’s last issue.

Other trends continue to develop in the investment committee space. Some note, for example, that committees have tended to use external figures in recent years in order to bring an independent individual into the process.

Some DFMs have also taken this approach: P1 Investment Management recently appointed an oversight committee, made up of external figures, to guide its position on ethical and sustainable investments.

Getting the house in order

Beyond segmenting clients, a revamp will allow intermediaries to reassess the effectiveness of their investment committees, given the different forms these can take. Graham Bentley, an investment consultant, suggests that firms focus on what they are offering, and on justifying any decisions made.

“A good investment committee recognises that it’s there to oversee the way a proposition works. That proposition has to be written down well so the committee has something to follow. If it’s just a compliance document, there’s no reference point to say why our portfolios are put together in a certain way,” he says.

“Are you arbitrarily picking certain funds? Or how do you choose funds if they are on a buy list? The risks [of not following a process] are that your oversight is lost. If there isn’t an investment process written down, then there’s no point of reference for the committee.”

It is not guaranteed that Prod will affect all committees. Because advisers structure their businesses differently, some will find the requirements may in fact come under the remit of other departments. Similarly, of those committees that are affected, some may simply have to refine their practices in order to comply with the FCA rules. This could involve better documentation, or more regular meetings and updates.

Mr Barrett explains: “Some firms are doing [the proper processes] anyway and need to formalise what they are doing, and do it a bit more frequently.”

Permission to launch

The new rules could also prove influential in the ongoing debate over whether advisers should run portfolios, or outsource this work.

Though the rush to outsource investment decisions following RDR implementation is well known, a significant proportion of intermediaries still prefer to run money themselves. In-house model portfolios continue to gather the largest proportion of client investments among Nucleus users, according to the platform’s latest Census research.

Some 45 per cent of users with in-house model portfolios will put more than 80 per cent of client monies into this option during 2018, according to the survey, up from 34 per cent in 2017.

Similarly, 43 per cent of respondents say they will not use a DFM over the longer term. However, this does not necessarily mean advisers want to take the discretionary route themselves.

“The interest in obtaining discretionary permissions appears to be waning,” the Nucleus paper notes. “In 2016, one in five responders planned to hold discretionary permissions, and this has dropped to under one in 10. The percentage that already hold [permissions] has remained constant at 8 per cent.”

The basic arguments for running advisory or discretionary models remain largely unchanged. An advisory set-up can make running money more cumbersome as any portfolio change requires client permission to go ahead. This can also lead to a proliferation of slightly different portfolios if certain clients fail to respond to requests for permission. Discretionary portfolios are more straightforward in this respect, because the manager can change portfolios without seeking the client’s go-ahead. But a firm with discretionary permissions must meet greater regulatory requirements.

For some, the logistical and financial burdens are also significant. As Money Management noted last month, Nexus IFA founder Kerry Nelson, an attendee at a recent DFM briefing at the FT, runs money but has refrained from getting DFM permissions because of capital adequacy and related issues.

With the Prod rules adding to the complications, advisers could be more inclined to back away from running money in house.

 “It feels to me like a large part of the argument of the firms to outsource, as an adviser, to a DFM or a model portfolio provider…. has never really been greater,” Mr Barrett says.

Needs must

For some, this may come down to the size of a firm, and the nature of what it offers clients. John Higginbottom, technical and regulatory business consultant for Bankhall, notes that while some companies stress their expertise in areas such as financial planning and outsource investment decisions, others focus on meeting client needs in portfolios.

“A number of smaller firms believe a key part of their client proposition that differentiates them is the delivery of client-specific portfolios,” he says.

Regardless of what investment offerings intermediaries choose, making sure these are suitable for clients has become a prominent issue.

“Suitability has gone to the top of the tree,” notes Mr Farquhar. “Investment committees spend much of their time ensuring their decisions are meeting suitability requirements on an ongoing basis.”

In the modern age, advisers must use enhanced due diligence to avoid the risk of shoehorning clients into generic offerings, particularly when it comes to the likes of risk-rated ranges. Some believe such concerns limit the appeal of outsourced investment services, particularly in an era of segmentation.

“The risk is that most advisers won’t have the same level of expertise and research capacity that an external DFM has,” explains Barry Neilson, chief customer officer at Nucleus. “But the adviser is best placed to think of solutions that meet the specific needs of their clients.”

He adds: “One difficulty of outsourcing is most DFMs have a set of models available. For example, if they didn’t want a client exposed to funds that short [sell], it’s difficult for the adviser to have a process of influence over the DFM to make sure those things are excluded. They can’t outsource the suitability element.”