David Boyle: Key questions in DFM due diligence

Every now and then the asset management industry throws us a curve ball that sends shockwaves throughout the investment world. They tend to look like one-off events, but in hindsight they have usually been building for some time. Few see them coming and the ramifications are difficult to call with any certainty. 

Those of a certain vintage will recall the names Barlow Clowes and Peter Young, and other scandals such as the split caps and the precipice bonds. Of course, more recently there is the high profile (ex) manager that encountered problems with too many illiquid stocks.

At such times, the best cause of action is to regroup, learn from them and make sure that all bases are covered in the future with sound due diligence practices. 

Given the ever-changing nature of the discretionary fund management (DFM) landscape, which now includes active, passive, ethical and more recently ESG strategies, a strong handle on governance could prove to be invaluable in reducing any unnecessary risk to a client's assets. 

It seems to me that strong governance is the key to avoiding disasters that are beyond simple poor performance. Though I will concede the Barlow Clowes scandal probably comes more under the ‘if it is too good to be true, it probably is' category
(a real note I found in an old client file).

When we undertake due diligence on an investment firm there are a number of key areas that are of particular interest to us and the presence of robust governance in each area is a strong positive.

Firm 

Whether a household name with a global presence or a boutique investment house with only a local reach, getting a feel for those in charge, the assets under management and any recent restructures is as good a place as any to start. Growing assets is a good sign, a kind of seal of approval from others using the firm. Yet even here, you have to be sure that it is not a manifestation of the herd mentality or FOMO (fear of missing out). Good governance within the firm should avoid one individual becoming a kind of Pied Piper of Hamelin.

Philosophy

There is no, single, right way to approach investment. Many have their own USPs, and DFMs are no exception. Choice is a good thing but understanding what sets your chosen firm apart from the rest of the industry is key. Make sure you fully understand the managers approach and, more importantly, that your client will understand it. Whether it is value, contrarian, or wealth preservers, what is important is that the investment managers stick to the mandate and remain true to their investment philosophy. 

Process

A solid investment process should be consistent and repeatable, so it is worth asking a few pointed questions - any red flags here may be cause for concern. Understanding a firm's approach to portfolio construction is vital if you wish to determine if the portfolio is achieving what it is mandated to do come review time.   

Most DFMs will attest that when fund/manager selection is concerned there is no substitute for wearing out the shoe leather with many travelling extensively to visit managers situated around the globe, whereas others will adopt a more desk-based approach. Most discretionary portfolios are fund based, so it is important that advisers are confident that discretionary managers are on the ball about how the portfolio managers of the funds they hold run their investments. The discretionary managers concerns should be identical to the advisers concerns about the discretionary manager.

People 

Firms pride themselves on the quality and professionalism of their people, and the benchmark is high these days. In terms of a team structure, it is pleasing to see when roles are clearly defined and responsibility for specific tasks apportioned accordingly. This is where you should look for strong governance.

There should be a team or person that is responsible for risk in the portfolios. They should have the power to veto investment decisions or at least bring to attention of the executive if they feel that decision is going to add unwarranted risk. Look for an investment committee or formalized peer review process. Beware the lone cowboy. 

Similarly, if a DFM is offering an ethical portfolio you would expect there to be an in-house specialist or team covering this area. Questions should be asked about this expertise. 

Stick to the fundamentals and remember that for most client investments there is no need to be tempted into higher risk strategies. In many cases, temptation is all it is. Good due diligence and evidence of robust governance should allow you to invest with confidence.

Of course, clients should be aware of the risks associated with investing, and spates of poor performance will be tolerated in most cases. What is less forgivable is when something labeled as korma turns out to be vindaloo.

David Boyle is support analyst for funds and DFM at Defaqto

This article appeared in the December issue of Professional Adviser's sister title Multi-Asset Review. To make sure you receive your own copy of the next issue, please do register your interest here

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