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Investment Support for Independent Advice: Article 1: Using an external investment adviser

Published: May 22, 2014 by Peter Foster, Fundhouse

This is the first in a series of articles discussing investment support for financial advisers. Taking the lead from offshore markets and based on what we see locally, we will be unpacking the options and identifying how these could be used by advisers and their clients.  This first article covers the topic of using external investment support in your practice.

 

Article 1:  Using an external investment adviser

At first glance this title may seem contradictory – why would a financial adviser employ external investment expertise in their practice?  After all, isn’t this the role of the financial adviser and the main reason why their practice exists in the first place?  Currently in South Africa this is largely the case, financial advisers tend to manage all aspects of the advice process inhouse – planning, risk profiling, investment selection, portfolio construction, asset allocation and sometimes even offering their own products.

Taking that as the status quo, we have more recently seen the momentum turn and advisers are starting to look for external help.  The reasons behind this change are varied.  Regulatory pressures are an often cited reason – having an external party lessens the burden on due diligence, governance and compliance.  We also see capacity constraints as a driver – making investment changes to a set of clients is cumbersome and time consuming and limits the growth potential of a practice. Having the investment support covered by an external frees up substantial time to see clients.

What would a typical service level look like?  Generally it will consist of one or more of the following areas:

  • Investment consulting to build portfolios which relate to the adviser’s practice and clients.
  • Supporting research, due diligence and compliance management.
  • Implementation through a LISP, using a FAIS Cat 2 licence (the advisers or the service providers).  This requires the end client to sign a discretionary mandate which allows for the efficient rebalancing.  Importantly the client doesn’t sign on each rebalance, this is covered by the mandate.
  • Ongoing reporting and support to help the adviser support their clients.

 

In the UK, approximately 45%[1] of the advice industry uses external investment support in some form.  The  main driver here has been regulatory pressure (via RDR) and consolidation – advisers have moved towards networks and other serviced models where their business and service capabilities are enhanced, and their regulatory risk lowered.  The obligation on advisers to perform due diligence and understand the investment choices they make on behalf of clients are onerous, and it is increasingly difficult to avoid the need to demonstrate that the ‘homework’ has been adequately covered.

That sets the scene for South Africa – when do advisers here start to take similar steps? To some extent it’s based on the options available.  Up until now the extent of support for advisers has been limited.  It’s a case we often make for the reason we started offering fund ratings in the first place – financial advisers are generally underserviced and oversold – meaning that their ability to access informed views on funds (as a large pension fund would receive) is limited, and the bulk of investment exposure tends to be marketing (factsheets and the like).  Marketing tends not to be useful in making investment decisions.

The alternatives though have not always been useful.  Past performance is generally a poor guide – much evidence demonstrates this.  Linked to this, historical ratings based on past performance tend to act more as a scorekeeper than a decision basis.  In the absence of informed views or a well structured investment process, the bad habits can start to creep in to the advice process, and this can be costly to clients. The Dalbar Study[2] is one way of gauging this – clients in funds tend to underperform the funds they are invested in due to poor switching decisions, trying to time the market and chasing past performance.  We have demonstrated this using the Investec Value Fund as an example:  the average client was over 2% behind the performance of the fund itself, per year.  Dalbar reports up to 7% difference between a client and the fund they are invested in (in SA we believe this number to be closer to 4%). The numbers can be material.

It’s also not only fund choice – portfolio construction is a complex area which very few are trained to perform. Given that advisers will use more than one fund to satisfy a client’s needs (manager diversification, for example), portfolio construction is a necessary part of the advice process.  This is justification alone to recruit investment expertise into your practice.

Leaving performance to one side for now, the business implications play an important role in this decision.  Being able to streamline the management of client investments can make a significant impact on the growth prospects of a practice.  Quite quickly the regulatory risk is mitigated (through investment process, research, documentation, etc), and time is freed up.

We see the demand between these two drivers (investments and business) being evenly balanced – using an external investment adviser is as much about managing business risk and growth, as it is about ensuring that good financial planning is implemented well.

Back to the UK for a second.  There are three primary service models available in that market.  Loosely this area is termed ‘discretionary fund management’ or DFM; in South Africa it’s more commonly known as ‘model portfolios’.  We believe it’s a bit broader than this and should include the full picture – advisory services as well as investment consulting to fit each adviser’s business model.  The UK market is split three ways:

1. Individual Client Model Portfolios (Bespoke): this is where an authorised DFM (CAT 2 licence holder in SA) will develop a bespoke portfolio and implement on a clients behalf. Effectively the adviser and the fund manager are the same – it’s a direct model for high net worth clients (£300,000 and above).
2. Managed Portfolio Services (MPS): this is a bulk model, more commonly seen in SA. Advisers set model portfolios to reflect their advice process, and an authorised DFM implements on their behalf, along with the requisite support (research, portfolio construction, etc). Minimums here tend to be in the region of £75,000 per individual. In SA minimums are generally set at the practice level (across all clients using the service). Fees should also be lower than bespoke due to the centralised management. Often the service here is direct, not only through a platform/ LISP.
3. Unitised DFM – essentially what we know as ‘broker funds’ in SA. A regulated unit trust / fund of funds specific to an individual adviser and their clients. This is often used to offer tax efficient options to clients and simplicity in management. However this generally comes at a higher cost.
Source: Defaqto[3]

We haven’t yet answered the question of whether external advisers have a legitimate role to play in SA.  We believe it does, quite simply because the end client and the adviser are better off, and advisers are empowered to service their clients and grow their practices. There is a proviso to this, that the service provider used is free from conflict, sufficiently qualified and fairly priced.

What can we expect in South Africa?  There is no doubt this is a growing segment of the market and we expect similar trends as found overseas.  The key for advisers will be how they differentiate between the various options.

In the follow up articles we will cover this topic more broadly, looking at practical steps and how these services work.  We’ll also be looking at fees and what the important decision areas are when considering this for your practice.