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DFM due diligence: What are the keys to success?

Do advisers need to reassess DFM due diligence in the wake of recent scandals?

Choosing the key to successThe use of discretionary fund managers has been growing in popularity in recent years.

As regulation, ongoing qualifications and general business administration are all taking up more of advisers’ time, it has become almost a necessity for many advisers to outsource research and portfolio management.

DFMs allow advisers to focus on other elements of financial planning rather than the time-consuming task of investment management and fund picking. They can also reassure clients that their portfolios are being managed by investment specialists.

But while there are plenty of advantages to using a DFM, they do not come without their risks.

The recent collapse of DFM groups Strand Capital and Beaufort Securities highlights just how important it is for advisers to do the necessary due diligence when outsourcing.

London-based Beaufort has been investigated by both the FCA and US authorities. An indictment from  the US Department of Justice was issued in March for alleged securities fraud and money laundering by the company and Beaufort was placed into insolvency after a successful application from the FCA to freeze the firm’s assets.

While there were initial worries private investors would have to pay the costs of Beaufort’s insolvency, it now seems likely that they will be protected by the Financial Services Compensation Scheme.

Meanwhile, Strand Capital had around 3,000 clients and went into insolvency in May last year. The FSCS declared it in default the same month, opening up compensation claims against the £86m in assets under management at Strand.

Divided but conquering? A deep dive into the DFM market

An administrator’s report details a host of failures in the run-up to its collapse, including being unable to value the commission payments that would have been due, unidentified bank accounts within the firm and a failure to have enough money to extend its professional indemnity insurance.

Advisers holding money with the firm had to be contacted individually after administrators were unable to get a comprehensive list of client names and holdings from a director. So far, the FSCS has paid out £5.7m to nearly 800 customers.

Picking the winners

Nucleus chief customer officer Barry Neilson says advisers need to reassess their due diligence of DFMs in the wake of the Beaufort and Strand scandals.

He says: “We are clearly in a world now where financial advisers are beginning to use a more limited number of product providers. Whether it is a DFM or one or two platforms, they have a concentration of risk to a smaller number of providers they wouldn’t have had previously, which makes due diligence even more important.”

Nucleus warns advisers risk damaging their entire business if they fail to carry out sufficient due diligence when selecting a DFM.

It is important to look at a DFM’s annual reports and accounts to understand if it is sustainably profitable

Neilson says that one of the key risks advisers need to look for in a DFM is its financial stability.

He says: “The due diligence process needs to examine the financial performance of the group to give the adviser an understanding of the DFM’s resilience in the market.

“It also needs to go beyond just doing research and looking at the investment performance of the model portfolios to consider the financial stability of the DFM.

“It is about really understanding the deeper characteristics they are engaging with and the likelihood that the business model is going to prosper in a competitive marketplace.”

He suggests advisers ignore the claims made in the marketing materials by DFMs and delve deeper.

“It is also important to look at the annual reports and accounts and to get beneath the higher-level numbers that might appear in a more sales-related document to understand if the DFM is sustainably profitable.

“However, even with a very thorough due diligence process, it is impossible to predict what the future might hold.”

Falling short

The Personal Finance Society has urged financial advisers to review their DFM agreements amid fears that thousands may be working with inadequate terms.

The agreements often treat the adviser as the professional client of the DFM, acting as authorised agent of the underlying investor. However, many advisers who may not appreciate the important technicalities have signed these agreements when they do not have the appropriate authority from their client to do so.

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  1. Apart from the obvious – companies house, independent reports etc – put a decent chunk of your own money with them. That’s probably the best due diligence of the lot.

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