One major fallout of the RDR is the surge in the number of adviser firms outsourcing their investment to Discretionary Investment Management (DIM/DFM hereafter) and there is every indication that this is likely to continue for the time to come. Even firms who currently run their own portfolios in-house are finding it hard to cope with the huge burden of research, reporting and rebalancing (which requires them to obtain permission from clients before any changes can be made).
Industry press is littered with articles on advantages of outsourcing investment management and the best ways for advisers to go about doing so. Yet there isn’t much discussion about the significant drawbacks to advisers going down this route. In this post, my goal is to present some of these issues around outsourcing to DIMs and to provide some food for thoughts for firms going down this route.
- Too Many Hands In The Pie
I have written previously about the many gatekeepers between the clients and the equity markets; Advisers, Platforms, Fund Managers are the most visible part of the chain, together with 12 or so unseen others! Throwing a DIM in the mix is just one too many and this layering of fees will only become harder and harder to justify going forward.
According to our friends over at the lang cat, cost of running DFM portfolio on platforms could be as much as 1.20% to 1.86%pa. When you typical add adviser fee of 0.80%pa on to that, then total cost of ownership to the client could be as much as 2.6%pa.
The onus is on advisers to demonstrate that every investment component, especially where there are additional costs, not only add value to client but that this additional cost does not wipe out the benefits.
COBS6.1A.16G – In order to meet its responsibilities under the client’s best interests rule and Principle 6 (Customers’ interests), a firm should consider whether the personal recommendation or any other related service7 is likely to be of value to the retail client when the total charges the retail client is likely to be required to pay are taken into account.
If we accept that global equity risk premium is around 3.5% a year (and you’ll expect that risk premium for a multi-asset portfolio would be even less), it doesn’t take a lot of imagination to argue that the cost may well outweigh the benefits.
- Pressure on Adviser Fees
Let’s face it, where a firm outsources to the traditional DIM charging % of asset, this exerts pressure of adviser fees. The typical adviser fee of 0.80% becomes very hard to justify where there are additional 0.4% (including VAT) paid to the DIM.
Also, the pressure on the adviser to be clearer about what it is they actually do for the client becomes even greater. The adviser will need to constantly highlight how they are adding value in ways not related to investment management; tax planning, cashflow planning, behavioural coaching etc. While these are incredibly valuable services, it will become increasingly challenging to justify charging by % of AuM, as they aren’t directly related to portfolio size.
One argument commonly used by those promoting DIM outsourcing is that there isn’t much value in investment management. They point to increasing commoditization of portfolio management, especially though technology as a reason why advisers should outsource portfolio management and focus on relationship with clients. However, once outsourced, the client’s still pays typical 0.4% inc VAT. This is an oxymoron.
Ultimately, there is value in delivering portfolio management to clients, however small. And planning firms who deliver this capability in-house as part of their service to clients will tend to command higher fees than those who outsource that service to a third-party that clients has to pay for. I know that’s hard to swallow but its true.
- Performance – Does it add up?
Fund management industry is facing unprecedented pressure right now, in term of performance and transparency. DIMs are right in the middle of the storm.
One reason DIMs seem to thrive is that they can hide behind the cloak of opacity when it comes to fees and performance. It’s incredibly difficult to measure and benchmark their performance. Personally, I am aware of only one service that enables you to compare DIM performance in any meaningful way (ARC), but the service costs five figures annual subscription fee, which is beyond what most advisers firm I know would fork out for a software or data service.
So adviser firms have to rely on data provided by the DIM, against the benchmark chosen by the DFM but no independent means to make any meaningful comparison with other credible alternatives.
- Mismatch of Risk
A major potential problem with outsourcing to DIMs, especially where there is no direct relationship between the DIM and the client is the mismatch of risk.
First, there is the language problem; where the adviser firms uses terms like ‘cautious’ and the DIM uses different terms, say ‘moderate’ for instance. Then there is the actual disparity in terms out what risk mean to the DFM on one hand, and what it means to the adviser and the client. Is the planning firm risk profiling tool set out give outcomes that aligns with the DIM’s?
Bear in mind a DIM works with multiple firms and unlikely they’ll be willing to change their process just to be able to fit one adviser firm. DIMs thrive on scale and standardisation and traditionally run model portfolios that they fit the adviser’s clients into. And so, to have any chance of overcoming this problem, the more likely scenario would be that the adviser will need to redesign their advice process and risk profiling to match the DIM’s.
And there is no complete certainty about where the risk lies. While one major sales pitch for DIMs is that they help advisers ‘derisk their businesses,’ it isn’t entirely clear this is the case. For one, there isn’t really any precedence in relation to the clients of an advisers seeking redress from DIMs when things go wrong. The FOS is likely to argue that it is the adviser who recommended the DFM and there’s where the liability lies. But, I may well be naïve.
Conclusion
I’m sure many DIMs and indeed firms currently outsourcing to DIMs would argue that some of the issues raised here are either not a problem for them or aren’t significant enough to outweigh the benefits. It’s also worth noting that not all DFMs are the same. There is a small number of offerings in the marketplace that are trying to do things differently; for instance, where advisers have greater involvement in the design and implementation of the investment process, and in some cases where the adviser firm directly covers the cost of DIM services rather than passing it on to clients. These offerings are far and in between, and tend to be offered by far less established players.
For advisers firms who decide to stick to their guns and keep their investments proposition in-house, there is the issue of whether they have the capability going forward, particularly in the areas of research and administration. Outsourcing elements of the process such as fund research and better use of technology (check out FasTrak and CreativeTechnology) could ease the administrative burdens of reporting and rebalancing. Perhaps firms with similar investment philosophies and processes may consider collaborating to share resources and may be even gang up to obtain discretionary permission to help reduce the administrative burden! Advisers are generally a resilient bunch and this breeds creativity. If there is a way, I’m sure someone would find it!
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Good morning Abraham – it’s been a long time, I hope you’re very well.
As always, a very good article. I have gone down the DFM route for some clients and so far it is working out well, but the points you raise here are points that are always in the back of my mind. While it may be a decent process in some respects the costs are a real factor and if I’m honest, the investment management is the part of the job I enjoy most. I’m probably going against the grain there but do hold qualifications to justify it, and feel I’m more interested than investment management than pure advice without the investment side..
I’ve had one client ask why they would use me when they can go to the DFM direct. It wasn’t part of a difficult conversation but a question the client had; of course we can justify it to an extent in that we manage the advice and outsource the investment decisions, but I am yet to be fully convinced that by doing this we are doing the client justice when we can often get just as good, if not better results ourselves.
With regard to the “on platform” route of DFMs, one problem that I come across time and time again is that a DFM has a long term view on investment and a client likes to see results at least every six months. There is a sense of educating the client here, but when I hear some excellent DFMs talk about the long term,they may see 20 years as long term whereas the client may well have other ideas. Of course that is where we come in in terms of advice but matching the two in that scenario can be quite difficult.
My last point – the adviser can’t wash his hands of the performance of a DFM he/she has advised, so in many ways, why not maintain in house and bear the responsibility of your own management rather than someone elses? At often quite a significantly lower cost.
Best wishes
Sam
A good article but one missing a significant issue on total costs (but one commonly also missed by other commentators). Isn’t most business actually ‘replacement’ business since most clients already have existing investments? In that case, FSA FG12/16 comes into play. This says that, no matter how many ‘bells and whistles’ and extra benefits and attractions you build into the new plan, extra cost, compared to the old plan, in excess of 0.5% RIY pa (may be lower for low risk or short time horizon) is difficult to justify. Many legacy plans, particularly life company products, with perfectly adequate asset allocation for the client’s risk level, have surprisingly low ongoing RIY (even if they once had high initial charges). This factor alone will preclude high charge new proposals for the majority of IFA clients.
Good shout Stanley and I tend to agree.
One question though, how would you treat adviser fees, if the current plan doesn’t include adviser charge? In other words, the comparison between the existing and recommended plans need to be on a like for like basis – product cost Vs product cost?
Abraham,
I know some advisers will try to do a comparison by leaving out adviser fees from both sides (because that’s much easier to do) but I believe strongly that the proper way is to include them for two reasons.
The first is that the basic TCF principle should be to illustrate ‘total cost of ownership’ for both propositions, not just the difference between them.
Secondly, this opens the opportunity to create a more level playing field in a number of ways, including additional adviser fees for cheap looking ‘off platform’ propositions which require manual intervention. For instance, what about rebalancing? The FSA was on record as saying that they regard this as so important that if a proposition does not include rebalancing, the adviser should explain the extra risk to the client. So the new proposition includes rebalancing but the old one would require manual intervention by the adviser to achieve the same. How much extra cost does that add (assuming the adviser charges rather than just ‘taking it on the chin’)?
We also all know that RIY calculations from providers are limited in what they have to include and omit items which can be important (transaction or switch fees for example). So my angle is that all ‘independent’ advisers need to be capable of calculating the RIY for their precise proposition (including the service level for old plans) themselves.
At this point I should declare an interest as a purveyor of such a tool!
This is a good point to debate, in my opinion the analysis needs to be both product and advice specific.
If an existing plan pays 0.5% trail but your service proposition is not priced at that point (and would possibly cost more than what you do charge if it has to be provided via an existing – let’s say off-platform – plan) then the advice cost must be separated from the cost of the product.
Stripping all advice costs from both sides facilitates the product cost analysis, which should include platform and DFM charges if relevant and be based on a reduction in yield calculation over a meaningful term. Preferably with the option to add in the advice cost to show its impact.
The advice cost and what is provided for it is controlled by the firm and is what it is. It is the firm’s ‘product’ and there should not be a regulatory line in the sand beyond which additional costs for the product most suited to deliver it to the client becomes unacceptable.
Possibly a bit off topic but still relevant overall, especially when there are many fingers in the client’s pie.
Benjamin, clearly a good point to debate as there is a difference of opinion. In reply, I query why would the advice fee be the same if the level of manual intervention to deliver one proposal is higher than another? Also, the requirement is to illustrate the total cost of ownership of either proposition, not just the difference, and this definitely needs the advice fee included.
Hi Sam,
Thanks for your comments and for sharing your own experience. An interesting question from your client and I’m sure that’s not the last time you’ll hear them ask you the same question. No doubt any adviser will need to regularly communicate how they are adding value to client but I think this becomes even more crucial where a DIM is involved in the process.
One question for you; if you enjoy investment management, why are you paying someone else to do it? Is that down to capacity issue within the business and give you more time to spend on client acquisition/servicing?