To segregate or not to segregate? That is the question!

29 September 2015

Fraser Donaldson – Insight Analyst (Investments)

Advisers, when recommending solutions to their investment clients are faced with a choice of funds or discretionary management solutions. Both are available through most tax wrappers and adviser platforms, so accessibility is not really a differentiator.

While there are some sound financial planning reasons for favouring one solution over another Defaqto have found that the main drivers for selection are personal preference and service expectations, and often it is the personal preference and the service expectations of the advisory firm rather than the client.

The regulators had anticipated advisors offering a range of investment solutions, both funds and discretionary and saw this as good practice. In their Final Guidance paper FG 12/16: Replacement business and centralised investment propositions from July 2012 , they state:

Several firms segmented their client bank effectively and designed appropriate solutions to cater for each segment. This included:

  • a preferred fund panel for transactional clients;
  • a suite of low-cost managed funds for clients with modest asset levels who required a low-cost ongoing service;
  • a model portfolio service for clients with a higher level of assets and investment experience, where the additional costs were appropriate; and
  • discretionary fund management for clients who required bespoke investment management solutions.

While they followed the more common route of selection by levels of assets available they were also careful to suggest that all recommendations are individual to clients. This effectively means that although an assumption can be made on basis of wealth this needs to be checked with the client that this is suitable for them as an individual.

So, what are some of the considerations when selecting one solution over another ? Lets take a look at some of the financial planning implications first:

All of the above are collections of underlying investments, so the main difference is in how they are structured. Portfolios from a discretionary manager are segregated, that is they are a collection of individual investments, so any transactions involving any of the portfolio investments are treated as individual trades for tax purposes.

This can be a good thing or a bad thing and is down to the individual clients circumstances. If there are no likely capital gains tax implications, CGT can be managed year on year and liabilities kept to a minimum. If, however, the success of the discretionary manager or the clients circumstances mean there are significant CGT implications this could mean that the discretionary manager is restricted in what they can do in some tax years, which could be detrimental to the performance of the portfolio.

It should also be remembered that managers of Managed Portfolio Services are unlikely to be able to take in to account an individual’s CGT position when trading, so this is something that the adviser will have to take in to account and take responsibility for. The upside is that CGT allowances are relatively generous and with careful management liabilities can be avoided or kept to a minimum.

For funds, all trading on the underlying investments is free from capital gains tax. However, all this means is that potential CGT liabilities are deferred until units in the fund are sold, but again, careful management over the years can mitigate against the likelihood of this.

In the end it is the client’s current circumstances and likely future circumstances that will dictate which is the more preferable solution from a tax point of view.

The advisor/client relationship should not be underestimated in all this. A selection of funds is likely to be under an advisory arrangement with the advisor firm and as far as the client is concerned the advisor is the one building a suitable portfolio for them. If it goes well, then fine. However, if the fund selection falls short in client expectations then it will be the adviser defending their decision making.

If a discretionary manager is used then there is a subtle change in relationship. The use of a discretionary manager can be positioned as the adviser, with the help of the client, employing an investment professional to manage their assets. In this instance if portfolio management falls short of expectations the perception is that the adviser and client are on the same side of the table, together expressing disappointment in the selected discretionary manager and together looking to find a replacement.

The initial selection process and due diligence should also be taken in to account. Although we have seen massive improvement over the last 5 years, some elements of information have been harder to obtain in the discretionary world. There are not as yet industry standards in the provision of either performance or charges information. This is by no means insurmountable, but does sometimes mean that advisors have to be particularly diligent when looking at and comparing on a like for like basis, information from discretionary managers.

With the arrival of MiFid ll next year, we would expect regulation to dictate how, and in what format key information is provided so this is likely to be a short term frustration.

Finally, what the client wants should be a key to any decision making. For instance, there will be very wealthy clients out there who have spent their whole lives amassing their wealth through hard work, innovation and risk taking. For some, the last thing they want is a full blown discretionary service where they are expected to be involved in the decision making. For them, a fund manager making all the decisions and an advisor keeping an eye on progress is all they will want.

For others, the thought of not being involved in decision making over what happens to their hard earned assets is unthinkable and a heavily service oriented discretionary solution is ideal.

It is certainly a case of horses for courses, with the wishes of the client being paramount and not always dictated by level of wealth

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