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Chris Gilchrist: Beware of outsourcing your investment

Advisers today are backing off fund selection in droves. Instead they are signing up to multi-asset, multi-manager, risk controlled funds or to discretionary fund management services for their clients. I think this will prove a mistake.

First, let’s ask why advisers are switching away from fund-selection advisory services.

A major factor was the credit crunch. Correlations between asset classes all went to one, so that diversified portfolios all tanked together and supposedly cautious portfolios were down 30-40 per cent at the nadir in 2008. Advisers who had swallowed the portfolio theory gobbledegook were shaken; they didn’t understand why it had all gone wrong.

Also, advisers realised they had their work cut out in preparing for adviser charging and that getting their act together on this was more important than trying to persuade themselves and clients that they could produce good investment returns at a time when markets were telling them they couldn’t.

Clearly, many advisers understand the distinction between being an investment manager and an investment adviser. These are different disciplines and in a professional financial planning process should be kept at arm’s length.

Why? To gain the client’s trust, the adviser should not have a vested interest in any specific investment the client owns. Only then can it be assessed dispassionately and the client advised to sell it if that is the right advice.

Do advice businesses really want to run their own DFM operations to give a better service to clients? Could there be a suspicion that they make more money this way? This can create a potential conflict of interest where there should not be one.

But financial advisers who justify outsourcing investment by saying they are just planners and don’t need to understand investment ought to leave the profession now. Investment is the core of financial planning and always will be.

Most of the key decisions financial planners ask clients to make are in essence investment decisions: paying off or not paying off mortgages, prioritising saving over protection, setting rates of accumulation and decumulation.Those who believe they can do all this from spreadsheets without knowing and understanding the nature of different investment strategies and styles, not to mention investment history, are sure to give poor advice.

On the other hand, those who understand investment strategies and styles are also capable of selecting investment funds. Most clients have long-term investment horizons. Advisers do not need to recommend more than a handful of funds run by managers with proven methods and long track records to meet most clients’ needs. You do not need to switch them actively.

Yes, portfolios of this kind may be more volatile than a benchmark, but so what? Don’t swallow the modern portfolio theory guff that claims this volatility represents risk to the client – it doesn’t.

How many DFM services have beaten the records of Neil Woodford, Nick Train, Harry Nimmo of Ruffer or RIT?

My contention is that if advisers create fund portfolios with the right timescales for clients, they can do better (and at lower cost) than most DFMs, which are run by managers far less talented than those cited.

I do not claim that such advisory services will be right for all clients, only that for many clients they are not only suitable but also capable of producing at least as good results as DFM services.

Chris Gilchrist is director of FiveWays Financial Planning, edits the IRS report newsletter and is the author of the Taxbriefs Guide, The Process of Financial Planning


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There are 5 comments at the moment, we would love to hear your opinion too.

  1. David Cowell, Myddleton Croft 13th August 2012 at 1:07 pm

    Whilst agreeing with a lot of what is said, I think that Chris is in danger of comparing apples with oranges. Whilst the are both fruit, I wouldn’t recommend that he tries to make marmalade from both.
    He appears to be comaring what are essentially equity funds with discretionary services which are very rarely invested solely in equities. Woodford’s funds were down more than 30% in March 2009 whereas our portfolios were down just over half that and we have ended up at roughly the same place.
    It is naive to state that investors shouldn’t be concerned over drawdowns. Human nature programmes it in.
    Whilst the managers he quotes are all good in their field, they are not setting out to do the same job.

  2. I think to refer to portfolio theory as ‘gobbledegook’ and ‘guff’ is nothing short of arrogant, ignorant and unprofessional.

    Different advisers have different processes. None of which are explicitly right or wrong, they are just different. Any fund or portfolio is a good one when it’s going up and a bad one when it’s value decreases. It’s awfully difficult to categorically say any one fund or portfolio is better than another, it will just be that it’s doing well at any one time.

  3. Chris, always good to create debate and we can all have different views as our advice world is far more related to art than science – but from your comments, not so related to ‘modern’ art ! You said ‘Don’t swallow the modern portfolio theory guff’. From my perspective I would rather follow science and the latest research and findings in finance than rely on the past performance of a fund manager who statistically could have their outperformance explained by nothing more than pure chance or luck.

    At the nadir of 2008 as you describe it, our largest (by invested money) asset classed funds had a negative correlation of -0.039 rather than the ‘1’ you mention. Furthermore, our lowest three risk rated portfolios fell by only 3.47%, 7.93% & 12.42% rather than the supposed 30-40% you allude to. Long term we can demonstrate in the mid fund of those three portfolios an equivalent annualised annual return of 7.06% since January 1994 with a standard deviation over that time period of just 4.85%.

    This is not to say how great we are, far from it, but it is to say that picking great fund managers who are meant to achieve far superior results than the rest of their competitors maybe a little far fetched.

    I agree with you that you don’t need a DFM or multi-manager approach but I’m far less confident in picking (and relying on) a single or couple of star managers. Mixed asset diversified portfolios with rebalancing seems to do everything we need and at low cost. Best thing is though, there is plenty of room for all of us with our strongly held and differing views – assuming of course that the FSA haven’t made a pronouncement against that as well !

  4. @ John Reilly

    The reality is that much of MPT has long since been discarded by academics. Any theory that is based on assumptions about the past is bound to come unstuck. Performance of assets is not an exact science.

  5. man on the moon 14th August 2012 at 8:23 am

    I am sure that this will be followed by a strong paid for rebuttal(S) by some DFM’s.

    I do think that most theories rely on the past to some extent and also to confirmation biases. Harry Trumans quote about a one armed economist proves this in my opinion.

    The Advisor building his fund own fund range and selling it at 1% a year has its own flaws too. I think that Chris may have covered this before.

    Indeed using a DFM has the added benefit that they can be wheeled in and given a kicking when things aren’t going so well.

    The latter does occcur from first hand knowledge.

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