Daniel Hurdley details a three-stage approach that should provide advisers with a robust and repeatable process for selecting discretionary fund managers (DFMs)
The increased use of DFMs by financial advisers to manage their clients' investments has received significant coverage in recent years. Outsourcing is not, however, a responsibility-free option for advisers and the onus is on them to take appropriate steps to review and rate the DFM's capabilities and suitability.
From a purely regulatory perspective there is an obligation on the adviser to review the market (Principle 9) and establish the suitability of the offering for clients (COBS 9.2). At all times, the focus of the exercise should be on achieving the best outcome for consumers.
In order to do this, the Financial Conduct Authority (FCA) has advised that research and due diligence needs to be conducted via robust systems and with adequate controls in order to be effective. As you can see here, the regulator specifically identified that the culture of a firm was important to the success of its research and due diligence process.
Beyond meeting the basic regulatory requirements, the FCA has identified that firms that demonstrated good practice had research and due diligence as a central function of the advice process and clearly showed they had the client's best interests at heart.
The better firms had either an in-built challenge in the process and/or individuals who were knowledgeable, enthusiastic and challenged the firm's approach. As a result, firms can reduce their own reputational risk, identify DFMs whose process is complementary to their own business structure and, above all, improve the outcomes and experience of their clients.
The three key stages of DFM due diligence are initial filtering, collating due diligence questionnaires and manager interviews. So how should advisers approach each stage?
1. Initial filtering
The initial list of DFMs might come from a directory or website listing, but these lists can be long and very general so a quick method to reduce the list to a manageable size is required. As such, this first stage is a straightforward case of verifying the DFM can deliver on any specific requirements of the client.
There may be tax or jurisdictional considerations to be addressed or the client may have their own biases for or against certain characteristics of a given firm. The DFM offering may also be unsuitable - either because it is focused solely on one asset class or specialist strategy, or the risks are too concentrated.
There are various online tools that can help in this situation - Asset Risk Consultants' own suggestus.com free research portal being one - but filtering can also be undertaken with a review of the respective company websites and literature or a call to the DFM.
2. Collating due diligence questionnaires (DDQs)
Using a standardised questionnaire helps to establish a comparable set of answers from each prospective DFM of both qualitative and quantitative data. Over time, the adviser can build a library of information that can be easily updated, saving time for future manager selections. Collating the data in a standardised format also helps when it comes to the review (see below).
The questionnaire is intended to function as a comprehensive, annual submission. It requests much of the qualitative information on:
* Background, ownership, regulation and resourcing of the company;
* Investment philosophy, process and high-level performance;
* Service delivery and accessibility;
* Details of fees, custody and reporting; and
* An indication of the systems and outsourced services employed.
The DFM should also be given the opportunity to submit other literature that might expand on their questionnaire answers, or provide greater clarity on their investment process or solution.
The FCA, however, highlights the need to focus on facts when outsourcing to a DFM - not the opinions of the provider such as the risks of a given investment solution. In particular, careful discrimination between opinions and facts contained in marketing literature must be made.
As an example, Asset Risk Consultants would request investment biographies for all key discretionary investment staff and an example of client reporting or quarterly valuation. Other useful information would be standard client presentations and take-on documentation, as well as risk management policy, risk-profiling documentation and, where available, the most recent audited accounts.
It is also important the manager can provide a sufficient track record to corroborate the performance of the proposed investment strategy under different market conditions. While we would not stipulate the performance history required, it would be fair to say that more information - that is to say, a longer track record - will be required for a non-traditional strategy than would be the case for a more traditional method of managing money.
The questionnaire should also collect additional quantitative data such as composition, scale and growth rate of client base, composition and turnover of relevant investment staff and monthly performance data, net of all fees, as well as the relevant benchmark comparators. The realism of the performance data submission should be considered - in other words, is it a fair indication of the typical client experience?
All due diligence data should be reviewed for completeness to ensure there is sufficient information for a full assessment. Any inconclusive answers should be returned to managers with requests for further elaboration as required.
The FCA expresses the expectation that more time will be spent on unfamiliar firms or asset classes than familiar providers. Using the questionnaire-based approach naturally leads to a greater degree of time being spent on new DFMs and products, with familiar services being quicker to check versus previous questionnaires from the same firm.
To aid the construction of a shortlist, it might be advisable to use a scoring process on the data collected. As an example, assigning a simple 1 to 5 score to each section of the data collated will provide a basis for comparison across the various DFMs in the selection.
A weighting could be applied to areas that are of most interest to the client, such as communication level or risk controls. Bearing in mind the FCA's comments on the benefits of a "challenge" process, the scores should be reviewed by a second pair of eyes to reduce the possibility of personal bias being introduced.
3) Manager interviews
Meeting with the DFM provides an opportunity to understand the investment philosophy, investment solutions offered, client base and state of evolution of the manager in question. The meeting also provides invaluable insights into the manager's ability to articulate and engage with clients.
It is a good opportunity to establish how the DFM is positioned within the wider universe of investment managers. The meeting also affords the opportunity to check the answers provided in the DDQ match the manager's presentation and their marketed performance is representative, and to raise any specific queries about the underlying performance data.
In terms of the investment offering, the adviser should seek to identify the strategies employed, and the risk metrics by which these strategies are managed. Investment vehicles, underlying asset classes and any regional bias should be understood, along with the range of potential investment currencies. Finally, details of minimum investment amounts, fees and other remuneration should be discussed.
After the meeting, the scores applied to the manager during the second stage should be cross-checked in case any areas of the manager's capability have been mis-scored.
Having completed the three stages of due diligence and filtering, the adviser should have a comprehensive paper trail documenting the full process of building the shortlist with evidence the shortlist was chosen based on the facts specific to the clients and the merits of each manager were considered objectively.
The approach detailed above should provide an adviser with a robust and repeatable process for selecting DFMs. Although there is an initial outlay in setting up the process, it can be made cost-effective on an ongoing basis by making use of online tools and other freely available information.
The onus is still on the adviser to make the right choice, but making an informed and defendable decision is made possible with the right information and process in place.
Daniel Hurdley is director of research at Asset Risk Consultants, an independent, privately owned consulting practice, licensed by both the Guernsey Financial Services Commission and Jersey Financial Services Commission to provide investment consulting services on funds and private portfolios. It has compiled an up-to-date library of standardised DDQs online that are freely available to IFAs at no cost at www.suggestus.com
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