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Why DFM due diligence requires a closer examination

What’s the difference between bespoke discretionary fund management, a managed discretionary service and a model portfolio service? To understand the DFM services on offer we need first to get the terminology straight, says Lawrence Cook, Director of Marketing and Business Development, Thesis Asset Management

There would have been a sigh of relief for some when the FCA’s Rory Percival announced a postponement in the thematic review of due diligence practices.

According to the regulator, its research showed advisers in the past were failing mainly in three areas: inadequate due diligence, inadequate consideration of cost, and risk profiling and mapping.

Irrespective of the timing, it is sensible for all participants to see what improvements can be made to due diligence. Whilst the outcome of such a review will doubtless have some interesting findings we shouldn’t be holding back development of best practice.

So if we took a view now, how should we judge the standards of due diligence across the industry?

It is not so long ago that Mark Polson of the Lang Cat and Clive Waller of CWC Research shared their paper on outsourcing by IFAs to DFMs. In short they found DFMs lacking transparency and advisers lacking understanding. This is a useful wake up call for us all.

Firstly, the term ‘outsourcing’ is widely misused. You cannot outsource something which you do not have permissions to do yourself. So an IFA with advisory permissions using a DFM isn’t actually ‘outsourcing’ in the strict sense – he is referring work to a DFM or arranging a service for a client. This might seem pedantic but if we are to get better at due diligence we ought to at least get our terminology right and agree what we are actually talking about when we say ‘outsourcing’.

For the purposes of this article then I will use referring to or working with a DFM rather than ‘outsourcing’. For better transparency we need to agree some common terminology.

I have had several quite circular conversations over recent months with platform providers and IFAs before clarifying what each party really means or wants. A good example is the ‘discretionary portfolio’. An IFA asked me: “Does Thesis run a discretionary portfolio on [a specific platform]?” To which the answer is ‘yes’. On this platform, Thesis runs a range of discretionary model portfolios.

The platform described these as managed portfolios and told the IFA they did not accommodate discretionary portfolios.

In discussion with the IFA, we explained the various types of discretionary service and it became clear that there was a lack of understanding about the difference between a bespoke discretionary, a managed discretionary service and a model portfolio service. DFMs have certainly not helped themselves with a range of different labels.

Defining discretionary

Let’s start with the word ‘discretionary’. It simply means the manager will make buying and selling decisions within a portfolio without asking the client for permission or authorisation. The authorisation to do this is provided within an initial client agreement (application form) that the client signs.

The word ‘discretionary’ does not tell you what kind of service this is other than that the manager has discretion to manage the portfolio. It does not tell you whether the portfolio is specific to the individual client, or whether it is managed on a model basis or if the investments within the portfolio are restricted to certain asset types such as funds only (i.e. no direct investment into stock).

Here’s what we call each service at Thesis:

• Collectives Model Portfolio service – a discretionary model portfolio that invests only in open-ended collective funds.

• Securities Model Portfolio service – a discretionary model portfolio that invests in stocks, open ended and closed ended collectives.

• Personal Investment Portfolio – a discretionary portfolio service that is bespoke to the individual client.

• Optima – a unitised fund which adopts the same asset allocation as the Model Portfolio service but wrapped in a fund; it invests only in collectives.

The first three are segregated portfolios. Therefore trading within the service may give rise to CGT. The last one being a fund defers CGT until sale of the units.

Getting this terminology straight is important. Not least because when an adviser begins a due diligence process he will want to focus on the services required for his clients. There is really not much point asking a DFM to complete an in-depth questionnaire if you want a model service and they don’t offer one. If answered well it will take some time to complete and some investment of time by the adviser to read it and digest it.

In this simple example above, just recording the fact you have disregarded a number of DFMs on the basis that they don’t offer the service required is a good way to start and narrow down the focus of due diligence.

Research – in-house and third party

To help IFAs there are a number of companies now providing information on DFMs. A word of warning here, few, if any, cover the whole universe of DFMs and some cover only DFMs that have paid to participate.

Companies providing analysis on investment performance include Asset Risk Consultants (ARC), which supplies in-depth reports on up to 60 DFMs. Its Suggestus service is increasingly used by advisers that are serious about really understanding how DFMs manage client money.

Financial Express has developed its Transmission service, which is focused on DFM model portfolio services. Many advisers will be familiar with the FE name and having used its fund research tools, and may find it easy to use its DFM research tools as well.

Defaqto provides an all round analysis of many DFMs which includes qualitative aspects in addition to investment performance.

Another important aspect about due diligence on DFMs is thinking through how you want a discretionary service delivered to the client. If the adviser wishes to retain responsibility for suitability then they need to ensure the DFM can support that with an appropriate client agreement. Some DFMs will insist on conducting part of the suitability process if you go to them direct which may not suit the client proposition of some IFAs. So be sure to have within the due diligence process some consideration about key regulatory responsibilities of who does what.

Remember if you are accessing discretionary services, such as a model portfolio, via a wrap platform then the client agreement is between the client and the wrap, not the DFM. The wrap platform has a separate legal agreement with the DFM. This means that the IFA is almost certain to retain the responsibility for suitability.

Irrespective of what discretionary service is required or how it is delivered, it is vital that the connection between the risk profile an adviser recommends matches the portfolio the DFM actually provides for the client. Most people now call this risk mapping.

Whether you are using a well-known risk profiler or a proprietary service be sure that when you say this client is ‘cautious’ that the DFM portfolio you choose reflects the same understanding of risk.

So a sensible part of due diligence would be to check that the DFM understands and can provide a risk mapping service. Done well this will give the adviser and DFM confidence they are delivering what is required for the client.

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