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Stephen Gazard: Advisers are failing on DFM due diligence

Stephen Gazard SBG MD 700

As financial advisers continue to adapt to life post-RDR, one of the big trends we are seeing is the increased use of third parties such as discretionary fund managers to manage clients’ investments.

This makes business sense as it frees advisers up to focus on other areas, such as guiding clients towards their financial aspirations.

However, one very worrying trend we are seeing is a failure by some to weigh up the risks involved in outsourcing. Advisers could risk detrimental outcomes for clients by not sufficiently considering the pros and cons of all third party support, including compliance services.

We are concerned that some firms are not sufficiently aware of their liabilities and duties as the overall guardian of clients’ financial arrangements. Many advisers we speak to erroneously believe outsourcing eliminates risk.

Instead it is the specific agreements between the DFM and the adviser which will dictate where the risks and ensuing responsibilities lie.

Most advisers have what they believe to be adequate processes in place.

However, on further inspection, despite their best intentions many do not, particularly around the investment outsourcing process. Advisers need to scrutinise their processes and ensure that the terms agreed between them, the client, and the DFM are watertight and provide the outcome intended. We are seeing instances of where these need to be strengthened futher.

As part of the due diligence and ongoing monitoring elements, advisers should make sure they understand every stage of the DFM’s investment process and are in a position to explain this in simple terms to their client.

An inability to do this could indicate an ambiguous and unsatisfactory process. In addition, the adviser should be in a position to understand how the investment process suits the client’s needs.

For instance, are portfolios managed purely on a growth basis or are there portfolios designed for clients requiring an income stream?

Is the service bespoke or a pseudo managed fund where all clients who match a certain risk profile are pooled into similar portfolios?

Advisers should also ensure the risk profiles they use are aligned to those used by the DFM.

There can be a mismatch between semantics and assumptions; this is something the FCA has committed to cracking down on.

For example, if a client is identified as a cautious investor, the adviser needs to ensure that the portfolio they invest in reflects this; there is likely to be a greater weighting towards apparently less risky assets, such as bonds, rather than potentially more volatile equities.

It is essential that any such assumptions, discrepancies and inconsistencies are clarified as early as possible in the due diligence process. Lack of clarity at this stage could significantly affect a client’s portfolio at a later date, and create significant liability issues for the financial adviser.

To further complicate matters, if only part of the client’s investment monies are passed onto the DFM, and unless there are split requirements, both parties need to work in tandem to ensure the ongoing suitability of the investment portfolios.

They will need to work together to ensure that portfolio drift is monitored, and realigned where necessary, in all parts of the client’s investments.

There are numerous risks for advisers who choose to outsource their investment processes.

They need to ensure every stage is set out in a robust and effective manner, placing clients’ appetite for risk and capacity for loss at the heart of every decision. Failure to do so could result in poor outcomes for clients and problems with the regulator.

Stephen Gazard is managing director at Bankhall

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  1. Not sure I follow “For example, if a client is identified as a cautious investor, the adviser needs to ensure that the portfolio they invest in reflects this; there is likely to be a greater weighting towards apparently less risky assets, such as bonds, rather than potentially more volatile equities.” Hasn’t the last decade (or more) proven this to be untrue. Isn’t it time we ignored this myth. Recently had a client die at age of 103 fully invested in equities. He believed that it was in his and his beneficiaries best interests to do so. And he had a lifetime to prove so! Surely it is what is appropriate for the client not what the CII, FOS or FCA think is best. They seem to be working from outdated text books that have yet to catch up with the real world. What would they suggest today with interest rates at 0.25%; gilts? Where would that get our clients?

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