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Matters of discretion

Peter Hugh Smith, director of Verbatim Discretionary Managers, details a range of issues for IFAs to consider when outsourcing investment selection to a DFM

The trend of advisers outsourcing investment selection is continuing in the run-up to the RDR.

One of the leading contenders for this business remains discretionary fund managers and with DFMs serenading advisers with a deal that offers to take the time and risk of investment selection off their hands, the delivery of a more bespoke client proposition and with no change to the all- important adviser/customer relationship, it is easy to understand why many advisers have already taken this route or are considering it.

However, there are a number of key issues I would recommend advisers to consider before they engage with any DFM. These issues fall into three areas, suitability, control and cost issues.

Suitability

Selecting a DFM is a challenge. For example, a recent selection project I worked on started with 120 DFMs being approached, full due- diligence questionnaires being received from around 60 and visits being undertaken to about 25 firms, from which four where selected.

However, selecting a DFM is only the start, as any DFM needs to be continually monitored to make sure it remains suitable. As a minimum, a DFM used by multiple clients should be assessed at least every year and probably twice a year with the manager responsible for the investment content of any customer portfolio being interviewed.

With the lack of meaningful performance universes in the DFM area, this process is critical.

A DFM also needs to manage to an appropriate mandate defined by the outcome of the adviser’s advice process. For example, for advisers using Distribution Technology’s Dynamic Planner, which includes a target asset allocation, any mandate provided to a DFM should include a requirement to manage to this asset allocation. It would be acceptable for the DFM to move away from this target allocation weight as a part of their management activity, although any divergence should be limited to tolerance levels.

Many DFMs argue they can manage to the same risk levels and can therefore adopt a different asset allocation.

I would urge caution in adopting this strategy unless it can be demonstrated that the DFM’s asset allocation is superior to the recommended target asset allocation.

Control

If an adviser does not have managing investment permissions from the FSA, it is not possible for the adviser to directly delegate to a DFM on behalf of their customer as to delegate an activity, the adviser has to be able to undertake the activity itself.

Therefore, the client has either directly, or via their adviser acting as agent, appoint the DFM. This includes DFM models on a platform or wrap if any trading is undertaken without the customer’s explicit permission being sought.

This results in a direct relationship being established between the customer and the DFM and, as a consequence, the DFM has a legal relationship with the customer, including a level of responsibility for customer suitability.

It is clear to see that this introduces disintermediation risk to the adviser. I would emphasise it is rare (although regrettably not unheard of) for a DFM to actively poach an adviser’s clients, although most DFMs would never condone such activity by their staff.

But if the customer decides that due to the presence of a DFM, the adviser is no longer required, few DFMs would refuse to take on the direct relationship.

Advisers need to be very careful that any service they recommend to their customers is properly structured and that any investment decision- making and trading activity is undertaken under an appropriate discretionary agreement.

Achieving this without accepting subsequent disintermediation risk is difficult but there are solutions becoming available where the DFM is isolated from the customer without compromising the discretionary appointment.

Cost

DFM services can be expensive. Not only does a DFM provide investment management but it also needs to cover the cost of relationship management, custody, sales, marketing, and other overheads.

DFM fees also attract VAT, increasing the cost by 20 per cent. This is unlikely to change, given recent rulings from the European Court of Justice.

Furthermore, most discretionary fund managers active in the adviser market tend to use funds as the building blocks of their portfolios rather than direct securities, adding a further cost.

Finally, if a DFM is accessed via a platform or wrap, an additional fee is added. It is not uncommon for the total cost of a DFM solution to be 2 per cent or higher before any adviser charge is taken into consideration.

But for advisers who consider these issues carefully and select appropriately from the more than 100 DFMs available today, a DFM can be an excellent solution for many of their customers, in turn supporting and strengthening the adviser’s value proposition and business.

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