Over the past decade, financial advisers have increasingly been ‘outsourcing’ the investment-decision making to a discretionary fund manager (DFM). While many advisers still prefer to pick their clients’ investments themselves, a growing number are turning to external intermediaries to put together and manage portfolios, leaving the advisers themselves to focus on other parts of their work.
In a survey carried out in 2016 by consultancy Threesixty, 87 per cent of advisers said they use discretionary fund managers.
So how do advisers decide whether to go for multi-asset funds, passive or active investments? When weighing up these choices, how much of a consideration is cost in the decision-making process?
Charles Newsome, the divisional director at Investec Wealth & Investment, which provides DFM services to financial advisers, says that DFM firms provide a wide spectrum of services, ranging from highly bespoke individual and state-of-the-art specialist arrangements to more generalised and fund-of-funds products. He explains that one reason why financial advisers opt to outsource to a DFM is that ‘some advisers see their role as financial generalists, who contract out certain specialisms to providers that offer greater expertise as well as better-resourced research capabilities, performance analysis, and comprehensive portfolio valuation and monitoring’. He adds that in opting for a DFM, advisers free up more time to focus on their clients and develop stronger relationships.
‘There’s also an alignment between the target market of most advice firms and the services offered by DFMs,’ argues Nick Dixon, investment director at Aegon. He says that most DFMs target their services at investors with £100,000 or more. Traditionally, DFMs were associated with high net worth clients, says Dixon. ‘They dealt directly with clients, and did not market themselves to a retail audience.’
However, this changed when ‘some DFMs realised before the financial crisis that a burgeoning mass-affluent population might benefit from a more sophisticated investment approach. They didn’t have the distribution, but the development of adviser-led platforms has provided them with access to this market.’ Meanwhile, he adds, by outsourcing to DFMs, financial advisers can ‘concentrate on providing a more holistic financial planning service to the client’.
Anna Sofat, a chartered financial planner and managing director of Addidi Wealth Management, explains that her company runs a range of portfolios of its own, but it still uses DFMs for clients in some cases: for instance, if they have strongly ethical criteria. ‘We run mainstream ethical portfolios, but where we think someone needs a really bespoke ethical portfolio, we could use a DFM,’ she says.
Similarly, she might use a DFM if a client of hers is looking for a bespoke Aim portfolio. ‘Where we think we can do a decent job and the reduction in cost makes a big difference, we will do it inhouse, and where it’s a specialist area then we use DFMs,’ she explains. Sofat’s team have used external services for some clients with very large portfolios, and ‘a couple of trust clients with very specific income mandates’. However, the vast majority of her clients’ portfolios – which comprise predominantly passive, smart beta holdings – are created in-house, which makes them more cost-efficient.
Martin Bamford, chartered financial planner at Informed Choice, is also in the camp of only occasionally outsourcing to DFMs. He adds: ‘We do outsource the construction of asset allocation models to a specialist third party. This gives us the foundation we need to carry out fund research in house and then populate these models.’ He explains that this is a good way for him to keep the cost of investing low for his clients, and also to ‘retain a high level of control over important parts of the investing process, especially risk management’.
From speaking with other advisers who use DFMs more frequently, Bamford says they typically choose to outsource ‘because they lack the resources or confidence to construct and manage investment portfolios in house.’ He adds: ‘A few do it in the misguided belief they are delegating all responsibility to the DFM.’
He argues that choosing a suitable DFM is just as challenging as building your own investment portfolios, as the responsibility for DFM selection ultimately lies with the adviser. ‘DFM selection needs to fit with your own investment philosophy and, if you’re an independent financial adviser, you need to consider the whole of the market, as appropriate to the client objectives.’
Cost has become a big factor when making investment decisions, says Bamford, although it shouldn’t be the only focus. ‘I would argue that value is always more important than cost, and going for the lowest possible cost option is counterproductive if it leads to poor risk controls, exposure to esoteric assets or poor longterm returns.’
At Wingate Financial Planning, financial planning director Alistair Cunningham says he doesn’t use DFMs at all, because ‘in our view, they tend to add a layer of cost without commensurate benefit’. He says that for a model portfolio service, where a DFM is investing in a portfolio of funds, a financial adviser firm of sufficient size can offer a similar service at a lower cost with its own investment committee. ‘The only significant difference is that clients need to give consent before any changes are made,’ adds Cunningham.
He also points out that ‘there is a very small, but increasingly interesting, offering from low-cost passive discretionary managers, who can off er portfolios at a cost comparable to collective investments (i.e. funds) but can work to an adviser firm’s mandate – this is an interesting hybrid.’
Wary of passive
Newsome says that cost is an important consideration for advisers choosing a DFM, but he is wary of choosing cheaper passive investments. ‘If you go down the more passive route, you’ll get a good performance over time, but with ETFs there’s constant danger that you might be getting into crowded trades.’
Moreover, while investors who bought the S&P 500 and FTSE 100 indices every year would get a good reflection of how the US and UK economies have performed, with slightly more esoteric ETFs that’s not necessarily the case. A further concern is that passive investment puts most money ‘into the largest companies rather than the next winners.’ Newsome argues that ‘you get more brainpower with active management, but of course you have to pay slightly more for it.’
Looking ahead, Newsome believes that DFMs will become increasingly core to more financial advisers, as research commissioned by Investec Wealth & Investment showed that around two thirds of financial advisers (64 per cent) believe it will be harder to keep investment management in-house over the next two years.
Survey participants pointed to due diligence demands as the key reason why in-house management services will be harder to provide (cited by 82 per cent of respondents), followed by a lack of a dedicated in-house research team (63 per cent) and too much administration (55 per cent). A third of advisers (34 per cent) said their time would be better spent looking after existing clients and finding new prospects.
In the face of this trend for advisers to outsource to DFMs, Sofat maintains that there needs to be more transparency when advisers survey the market. ‘There has been a huge trend to outsource to DFMs, and sometimes that does worry me,’ she says. ‘While the cost of portfolios is coming down, there is still a range [of prices] there.’
She cautions that many DFMs have core holdings in their allocation and simply tilt them as conditions change. ‘Sometimes they will get it right and sometimes they won’t, so the overall returns won’t necessarily have anything different from the underlying market.’ She continues: ‘They have a habit of using alternative investments to manage risk, which adds costs; there may be cheaper ways to do that.’
Lack of transparency
A fundamental challenge is the perennial problem of benchmarking DFMs in terms of their performance. ‘If you look at mainstream funds, all the data is out there and it’s easy to compare funds, and see what’s in them – that isn’t the case with DFMs,’ says Sofat. Currently, she concludes, there are no comprehensive and independent records with which advisers can assess DFM returns over time.
That’s why it’s important to make your own enquiries if you’re a client who is seeking investment management services. First, it’s worth asking any adviser you are thinking of using to manage your investments whether they outsource the investment part of their work to a discretionary fund manager. If so, find out to whom, and why they choose this particular provider. What kind of funds do they use – active or passive? Do they construct bespoke portfolios or allocate money to a portfolio from a set of ready-made model portfolios? What has their record with other clients been, and what are the charges involved?
DFMs may add value, but they also add another layer of costs, so do make sure you know what you’re paying for.
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