What does good look like?

Fraser Donaldson – Insight Analyst (Investments)

We have seen this question popping up in the financial media on a reasonably frequent basis. On the face of it, it seems like a fairly simple question. However, I think the question is flawed. It should be more along the lines of ‘What does the client want their discretionary manager to do (or be)’? It then quickly becomes apparent that there is genuinely no right or wrong answer to this question. Beauty is in the eye of the beholder they say, or put more simply; It depends.

There are no shortcuts to this wide ranging question. The only way that an adviser can reasonably accurately answer this question is to answer it for each individual client. It is perhaps unreasonable to expect advisers to do in depth whole of market research for each individual client. However, good in depth client segmentation will provide the foundation for all future decision making.

So what does this mean ? The answer to the question ‘what does good look like?’ can only be sensibly applied to the process of selection, not the propositions themselves (unless done client by client). So, perhaps the question should be: ‘What does a good selection process look like’?

This then all becomes about following a robust and repeatable process, which may look something like this:

Client segmentation

The foundation of all decision making within an adviser practice. Knowing all about the client invariably leads to the most appropriate service to provide for those clients. This would include not only the clients wealth, but other significant factors such as appetite for risk, timescales, goals, future earnings potential, accumulation phase or decumulation phase.

The decision to outsource

This would follow an in-depth review of resource and expertise within the adviser firm. In other words, is it in the best interests of the client to manage their investment portfolios in-house or would outsourcing to a third party increase the likelihood of achieving client goals?

The most appropriate solutions

What type of solutions are most appropriate for clients, based upon the results of client segmentation. A small number of different solutions are likely to cater, appropriately, for the vast majority of clients. Advisers then need to prepare to make alternative arrangements for clients with non-standard circumstances. This may include a bespoke financial plan if costs, resource and expertise allow or simply referring the client on.

Selecting the solutions

There should be evidence of good due diligence here for each type of investment solution selected. As documented by FCA (FSA as was) in ‘Final Guidance Paper FG 12/16 (Assessing Suitability: replacement business and centralised investment propositions)’, this should be a minimum of:

• terms and conditions
• charges;
• provider’s reputation and financial standing;
• range of tax wrappers that can invest in the solution;
• type of underlying assets invested in;
• flexibility to meet individual client’s needs and objectives; and
• Provider’s approach to undertaking due diligence on underlying investments.

In addition, a deeper due diligence should be undertaken which may include:

• Performance: bearing in mind the needs of the client group (risk targeted, absolute returns, return focussed)
• Type: Active, passive or neutral.
• Approach: It is important that the investment philosophies and process of the discretionary manager broadly coincide with that of the adviser. This will make the relationship, potentially a very long one, run that more smoothly
• Asset expertise: do the managers and analysts exhibit the expertise and resource to run the asset types they expect to include in portfolios ? (eg property, derivatives, hedge)
• Who is running the money? For advisers, managers in the discretionary world are not as well known or high profile as they are in the fund world. Investigate their track record at current and previous firms.
• Cost: Look beyond headline rates for annual fees. Challenge the headline rates as these can be up for negotiation. Look at the cost of underlying investments, particularly if funds with their own annual fee. Also check the potentially long list of addional administration fees that may include anything from transaction fees to dividend payment fees.
• Exit arrangements: Make sure that this is not too complex or potentially costly. Are there exit penalties ? Could a client transfer holdings out either in to their own name or to the names of an alternative DFM ?
• Engagement: Selected DFMs will in effect become business partners, hopefully for many years. It is important, therefore, that the relationship between all parties is a good one. We believe that testing that relationship, through face to face meetings before selection, is very important.

This due diligence is about giving both adviser and client the confidence to commit, potentially, significant funds to a third party.

Client needs

At the point of client recommendation there are of course other factors that need to be taken in to account that are specific to the client. Appetite for risk, goals, timescales would all be included here and then it would become clear if the client was in the right segment.

Monitoring

Ensuring that the DFM’s continue to meet client needs is as important as the original selection process. Formal, regular (at least yearly) meetings between adviser and DFM should be agreed where any issues or concerns are raised and addressed. This could fall under categories of performance, service and/or administration.

Advisers should also regularly (at least yearly) repeat the selection process in order to identify any potential replacements or additions to DFM panels. Selected DFM’s should realise they are in a privileged position in that advisers are not going to want swap providers unless there are significantly standout alternatives. In exchange for this relatively ‘sticky’ money, DFM’s should be as flexible as possible and address any issues in a positive fashion.

So, while there is no one best looking DFM, there can be a rather handsome looking selection process, giving rise to a selection of solutions that appear attractive to different groups of clients.

In summary, good decisions will follow if you:

• Know your own capabilities and limitations
• Know your client
• Know the market and your outsourced solutions
• Know where to go for help

Finally, so as not to spoil all the good work, document the whole process so it can be repeated and produced for the regulator if requested. Remember, in regulatory terms if it is not documented, it doesn’t exist!