The evolution of DFM due diligence

22 October 2018

Fraser Donaldson looks back at the evolution of the selection process for advisers for discretionary fund management proposition.

This article was originally published in Multi-Asset Review.

Fraser Donaldson, Insight Consultant (Funds & DFM)

At any point in time, when you look at a process or methodology, it always looks obvious and clearly the only way to do things. It is always difficult to imagine that things were done differently in the past. It is even more difficult to imagine that at the time, this too appeared obvious and was viewed as the only way to do things.

Evolution of the selection process

I find this thought a little unnerving in that, however we do things now, there is a fair chance it will evolve into a different way of doing things in the future. I suppose we should not beat ourselves up over this - just accept that things evolve and be prepared for inevitable change.

For those of us who have been around for a while, it has been fascinating to watch the evolution of the selection process for advisers for discretionary management propositions. There are a number of industry commentators - and I include myself among them - who have written extensively, not to say frequently, on the subject over the last decade. In the main we have focused on proposition selection in order to help populate panels or 'centralised investment propositions - or 'CIPs' for short.

It was nearly 10 years ago that we had the first inkling discretionary management could make a return as a mainstream investment offering as Defaqto was commissioned to do a piece of consultancy comparing discretionary propositions in the market against fund of funds.

Even at the time, with no real demand from our clients for discretionary fund manager (DFM) data, we could see that discretionary firms were taking notice of the extraordinary growth in fund of funds investing throughout the first decade of the new millennium. We knew DFM was coming back ...

It was a slow start though. When we asked DFMs for data, many of them were genuinely baffled by why we wanted charges and performance data - they really believed name and reputation alone would be enough to secure them business. The second major obstacle was that most adviser business was being placed on adviser platforms. To appeal to the adviser market, the DFMs would have to give up custody of assets.

The Retail Distribution Review

It was the Retail Distribution Review that was the real catalyst for growth in this area. Advisers accepted that running client portfolios on an advisory basis was probably not in the best interests of either the client or the adviser firm.

There are notable exceptions, of course, but outsourcing became the order of the day. Fund of funds seemed to get a rebrand and, where possible, started being called multi-asset funds. For their part, DFMs quickly got over the custody of assets issue and started employing teams that were used to dealing with the adviser market.

At this early stage, it seemed that due diligence was fairly basic.

Regulatory guidance

Leaving aside bespoke, which to some extent was still being looked at based on reputation and individual client requirements, managed portfolio service propositions were often being selected for panels and CIPs as a result of having a wide range of portfolios to choose from. There was some guidance from the FSA (now FCA) in 2012, which suggested looking at:

  • Terms and conditions of using the CIP;
  • CIP's charges;
  • CIP provider's reputation and financial standing;
  • Range of tax wrappers that can invest in the CIP;
  • Type of underlying assets in which the CIP invests;
  • CIP's flexibility and whether it can be adapted to meet individual client's needs and objectives; and
  • CIP provider's approach to undertaking due diligence on the underlying investments.

This was still very much geared towards looking at the firm and the proposition as a package of options. The range of portfolios within a proposition have been, and still are to some extent, viewed as a family, with advisers recommending from the portfolios available the one that is closest to a client's requirements.

In the following years, the regulators have added a little more flesh to the bones, suggesting due diligence should be going a bit deeper, perhaps looking at investment style, philosophy, the managers' experience and the structure of the investment team, among other things.

More recently, as a result of the FCA's Asset Management Review, it has been suggested more consideration should be given to the use of passive-based portfolios over active portfolios on the basis of cost. This makes more sense now than it did 10 years ago, as one of the key drivers for selection has been risk. In other words, while there is an argument that active management can indeed produce superior returns, is there any need to take the added risk if client outcomes can be achieved without doing so?

Where are we now?

So where are we now? Will we look back in 10 years' time and chuckle at the simplicity of the due diligence we embarked upon? Well, we shouldn't. The level of due diligence we all do is governed by the amount of data that is made available by the discretionary managers and sometimes guidance from the regulators. In less than a decade, it has gone from a reluctance to provide any information at all to a position where the majority of DFMs are happy to provide advisers with almost anything they need.

These days, there is no need to look at DFMs as a package of options. We have enough data to look at individual portfolios within a range. Some advisers already do this - and a few always have. As a process, this makes sense to me.

Just as within fund manager ranges, there will be portfolio managers who seem to be able to manage all portfolios well, some who may be more successful at one end of the risk scale and not so much at the other - and there will always be a few who seem to be poor across the board. Our own research system, Defaqto Engage, is already geared up to workflows that look to individual portfolio selection and this feels right.

The real question then is, what will we be doing in the next five or 10 years that may make the due diligence we do now look a bit simplistic or, heaven forbid, just plain wrong. Answers on a postcard?

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