Choosing a DFM – the importance of doing your homework
For adviser use only
Outsourcing investment management to a discretionary fund manager (DFM) can enhance your investment proposition to clients. It can also lower the business risks and costs associated with managing investment portfolios and create more time for you to focus on developing client relationships.
But to realise the potential benefits offered by a DFM you’ve got to partner with the right one. Carrying out detailed due diligence when selecting the most appropriate DFM will keep your business compliant and give you the best chance to build a long-term relationship that benefits you, the DFM, and, most importantly, your clients.
Where to start?
Perhaps the best place to start is with your existing processes. Do you have a structured due diligence process in place for selecting partners and assessing their suitability? If so, when was it created, how often is it updated, and is it still fit for purpose?
In a recent thematic review, the Financial Conduct Authority (FCA) found that “At some firms, a lack of structure in the research and due diligence process meant the results were not always up to date or challenged adequately.”
Nor is size any excuse for not having a well-structured process in place as the regulator went on to explain in the same review: “The size of the firm was not a barrier to good research and due diligence. We saw examples of small firms, including those with a single adviser, carrying out robust research and due diligence.”
The regulator understands and appreciates the potential benefits offered by a DFM, but it has also expressed concerns in financial guidance issued to the market.
In this guidance, the regulator outlined fears that discretionary fund management could be used inappropriately as a ‘one size fits all’ solution, and that it could lead to investments being churned or switched without adequate consideration for clients’ best interests. The regulator also highlighted the need to make sure that the charges associated with using a particular DFM offered good value to clients.
It is important, therefore that your due diligence process addresses these concerns and that you can provide evidence of this to the regulator. This process won’t just help ‘cover your ass’ but much more importantly, it will help ensure you choose the right DFM for the prosperity of your business and your clients.
Finding the right DFM
Your due diligence on any DFM should explore issues including financial stability and strength, its longevity in the market, the amount of assets it has under management and the split between model portfolios, bespoke portfolios and funds. And, of course, key considerations like FCA permissions and whether there are any complaints in the firm’s recent past may quickly rule out potential partners.
There also needs to be a cultural fit, so you should investigate things like a DFM’s corporate culture and the priority it puts on customer outcomes. Where possible it’s best to get tangible examples, whether in the form of written material, case studies or testimonials.
You’ll want to know what their investment pedigree is, what credentials and qualifications their key personnel have, and evidence of past success. The resources at their disposal are also crucial, not just in terms of people, but also technology and infrastructure. How big is their research team and what modelling software do they use to create portfolios? These are the basic indicators of capability and the firm’s ability to take on more business and manage it effectively.
Assessing the investment proposition
In addition to assessing the DFM as a business, there’s the actual investment proposition to investigate. Given you still retain responsibility for best advice, it’s crucial that the proposition offers a range of options appropriate to your clients’ needs, particularly from a tax planning and risk/return perspective. How many portfolios are available? Are they designed for different objectives? Can the portfolios be used in any of the on-platform tax wrappers?
The key objective here is to assess the DFM’s capabilities to manage investments. What makes them better than the many other alternatives; what is their record and how likely are they to be able to repeat past successes given their investment process and expertise.
In doing so you’ll want to get into the nitty gritty of what’s under the bonnet of the investments they offer. For example, what asset classes, rebalancing strategies, benchmarks and risk management tools do they use?
Once you’re satisfied a DFM has robust, repeatable processes and sufficient investment expertise, it’s important to stand back and ask some additional questions. What do they believe sets them apart from other fund managers or direct competitors? Has their track record justified the fees? How will you know whether they’re delivering value for money? Are you clear on their investment objectives? Are there tangible parameters for success, for example, outperforming a benchmark over pre-defined time periods? What proof do you have that they can deliver what they say they will?
Knowing the cost of using a DFM is very important and market expert Mark Polson of the Lang Cat explains it very clearly when he says:
“Anyone who doubts that cost to clients is a completely fundamental part of suitability for the FCA needs their head read. You can whine and moan as much as you like about knowing the price of everything and the value of nothing, and that clients don’t care, but if you don’t know the total cost of holding a portfolio over time on your chosen platform or platforms, and how that compares to the market generally, you’re not where you should be.”*
You, therefore, need to be very clear on a DFM’s charges for managing a portfolio, whether or not they include VAT, and where the charges are taken from. Do charges vary across the range of model portfolios offered by the DFM and are dealing charges included? If not, at what level are they set and how much would they be expected to amount to over a particular period of time?
Service and support
The quality of the service provided by the DFM will have a bearing on whether the relationship can be successful in the long term. Does the DFM have a dedicated intermediary team and what percentage of business comes via financial advisers? What sort of practical support is available and what level of information is provided in terms of investment performance, portfolio updates, and market commentary?
It’s also important to understand how this information is distributed, what sort of online service and functionality is in place and what telephone and/or face-to-face support is available if needed.
Be certain in your own mind
Research from Defacto** found that 43% of advisers were outsourcing their investment proposition and that this figure was on the rise. It also highlighted that 72% of these advisers were using discretionary management services when outsourcing.
If you decide to go down this road, there’s no prescribed due diligence process to follow when selecting a DFM. It’s up to you to prioritise your clients’ needs and to make sure that a DFM can meet them effectively and provide a beneficial and appropriate service.
The issues in this article are not exhaustive, but they provide a starting point to get you thinking about what you’ll need to cover when carrying out due diligence. The good news is that once you’ve got a well-structured and consistent due diligence process in place, it’ll give you something you can evolve for the future and enable you to demonstrate how you’re making the most appropriate decisions for your clients.
*Brewin Dolphin, Insight for advisers, Mark Polson: Due diligence - it matters
**DFM propositions on platforms, case study – Defaqto April 2015