Imagine you have a new neighbour who is a keen golf player and he wants to join the club you attend. He asks if you can help him obtain membership. He mentions his last club had recently dropped the handicap level and he was frustrated by the number of relatively novice golfers clogging up the greens.
You tell him that is not a problem at your club: they have very clear handicap level rules and, when you checked, you were assured they were not going to change. You agree to propose him for membership.
His application goes through and he pays the hefty membership subscription. A few days later, the club announces it is lowering its handicap level to allow relatively novice golfers to have access to the greens. Your neighbour is not happy and you are less than thrilled yourself.
He asks the club for a refund. The club says it will not refund his membership because it was down to the member who proposed him to ensure the club was and would remain suitable for him (and they can point to the membership small-print to confirm it).
This infuriates you as you had no idea you would be financially responsible should there be a mismatch between what your neighbour expected of the club and what it delivers. Sounds pretty unfair all round, does it not? Luckily, I doubt this is a situation that actually exists for members of golf clubs.
However, many advisers who think they are outsourcing to a discretionary investment manager are at risk of finding themselves in this sort of situation, albeit one that swaps golf for the significant investment pots of their clients.
This is because many advisers are unaware that, unless client “ownership” is handed over completely, it is not technically possible to completely outsource. Unless a well-documented and well thought out partnership is formed between the adviser and DIM, there is a real risk of a suitability gap appearing and the adviser finding that, ultimately, the buck stops with them.
Many advisers recognise the skills and processes required to run portfolios to a professional standard and in line with clients’ expectations are incredibly time-consuming. Referring investment management to a third party removes time and business profitability issues. However, many advisers believe it also removes the investment management risk and, unfortunately, this is where the problem lies.
In its Conduct of Business Sourcebook, the FCA is clear about how DIMs can offer a service to investors, requiring them to take reasonable steps to ensure a decision to trade is suitable for the client.
However, given the rising popularity of model portfolios and most providers’ desire to limit regulatory risk, the operating framework most DIMs use relies on an “agent as client” approach, where the DIM has no direct relationship with the client.
Using this approach pushes the investment suitability risk back to the adviser as the agent of the client. Now the adviser is in the position where they must take reasonable steps to ensure a decision to trade is suitable for the client.
If the adviser is not aware they have this responsibility then there is a suitability gap, where neither party is fulfilling that function. In addition, if the adviser must now check each investment decision before it is made (which is practically impossible), they have also failed to remove the investment management risk from themselves.
This means that, should a client become unhappy about the nature of their investments and seek compensation due to the unsuitability of an investment, it is the adviser who will likely be responsible in the eyes of the regulator.
The Personal Finance Society published a paper in February – entitled Adviser Research and Due Diligence on Discretionary Investment Managers – which starts to articulate these issues. I would encourage you to read it. This is a ticking time bomb for advisers and I would strongly advise any agreement with a DIM be scrutinised with some urgency to ensure there are no nasty surprises in the future.
Mike Roberts is chief executive at PortfolioMetrix