Financial strength: Is your chosen discretionary partner here to stay and can they maintain and evolve their services?

The fundamental reasons for choosing one discretionary manager over another are the philosophy of the discretionary managers and their success in terms of returns in carrying out that philosophy. The service received by the client and the adviser is also an important factor as it means that clients are happy and advisers can work efficiently.

Having narrowed the DFM universe down appropriately given these criteria, the next stage is to ensure as far as possible that the firm can continue to provide the service and investment outcomes in to the future. It is fair to say that the financial strength of the firm will have a significant bearing on this.

Consider the type of firm

The Financial Conduct Authority is very focussed on advisers carrying out meaningful and robust due diligence on any products or services they recommend to the client. With no formal financial strength ratings this means that advisers have to build up their own picture of the financial strength and status of a discretionary firm.

There are some headline ‘assets under management (AUM)’ figures that Defaqto utilises in assessing discretionary firms, and it's not just the bigger the number the better. We would look at firms that are standalone discretionary businesses in a slightly different way to those discretionary firms that are part of larger businesses.

Standalone discretionary business

The first thing to consider is that if the only business of the firm is discretionary management it should have a built-in impetus to succeed as there will be no competing lines of business. In short, goup AUM and discretionary AUM are one and the same.

Discretionary AUM growing year on year over and above market growth is an indication (not a guarantee) that the firm is thriving and they will be in a good position to provide resource when required (client support, investment managers, technology, adviser support).

However, you cannot look at this in isolation. For instance, if a firm claims to offer clients a premium service and advertises expertise in multiple markets using multiple assets, that is implying a considerable skill set and people resource. You need to look at AUM, look at revenue in terms of fees based on management charge and make a judgement as to whether this depth of skill set is supportable.

Relatively low AUM should not necessarily be seen as a sign of weakness. The firm may be receiving financial support for a period of years until profitability is achieved. They may be utilising superior technology which increases efficiency or simply outsourcing some investment or administration functions and cutting costs there.

If there are any doubts, advisers should engage with the firms and ask them how they intend to provide the service they are advertising.

Discretionary firms as subsidiaries of larger businesses

We feel that this structure has a different dynamic to standalone businesses. The fundamental question of profitability is clearly still important, but beyond that the judgement should be around how important the retail discretionary business is to the parent company.

The starting point for analysis here is then a function of group AUM, discretionary AUM and for retail offerings the percentage of business received through the financial adviser distribution channel.

Say there are two discretionary firms with relatively large amounts of discretionary AUM – let's say both have £2 billion. One may be part of a group that has £200 billion AUM through other product lines, the other may be a part of a group that has, say, £10 billion AUM through other product lines. As a source of revenue, the latter is going to be more important to the group business than the former.

Adviser support

An equally troubling scenario is where discretionary firms continue to offer the solutions but have decided to retreat back into the private client world and no longer support the retail financial adviser distribution chain. Defaqto sees this as a real possibility. Discretionary management and outsourcing is a hot topic at the moment and as such many discretionary firms have turned their attention to this market over the past two or three years.

Competition is intense in the retail market. We cover some 180 different discretionary solutions on our database. While they may all survive into the future in some form, we anticipate many will withdraw back into the private client or institutional market from whence they came

While the headline asset figures are a help, they do not necessarily tell the whole story. Defaqto always suggests engaging with firms before making a decision. What it all boils down to in the end is the discretionary firm's commitment to the retail market, and this is always going to be a subjective judgement on the part of the adviser. However, the more engagement with the firm, the more straightforward it will be to make that judgement.