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This is the second article in the model portfolio series.  Here we will be discussing what to look for in a service provider, and what to expect from a service level agreement (SLA).

ARTICLE 2:  WHAT TO EXPECT FROM AN EXTERNAL INVESTMENT ADVISER

In the previous article we covered the concept of bringing a specialist investment adviser into your practice. Assuming that you are actively considering this as an option, we will now deal with what to look for and what to expect from a service level when going this route.

At the outset we must disclose our interest – this is a service which Fundhouse offers as an extension of our fund research offering. The discussion below does not focus on what we do alone, rather what should generally be expected of any service provider with whom you engage.

The key role of an external provider is to add particular investment expertise to your practice. There are secondary benefits to the service, like administration efficiency and improved governance and reporting, but it’s essentially investment expertise which you are adding to your client proposition. This is worth further exploration – what type of experience and skills are needed to fulfil this role? There are two core skills which we discuss below: understanding each fund used, and how to build these together into a portfolio for a client.

Understanding unit trust funds and simplifying choice

This function is less obvious than it sounds. Apart from the excessive number of funds to choose from in SA (currently over 1000; in our view the useful number is somewhere around 200), what is generally presented in fund managers’ marketing documentation is not all that useful. It does not for example provide a guide for the adviser as to how well equipped their team is, or how thorough their research process is. It also doesn’t provide a view on the stability of the business so that you, as the adviser, can make an investment decision which won’t need to be changed as a consequence of business level changes.

The nature of unit trusts when compared alongside their institutional fund cousins, is that they succeed or fail based on the ability to market them as much as their ability to perform. Excessive marketing then comes alongside excessive fund choice, and it is one of the primary roles of your investment adviser to be able to simplify this choice for you and clear out the noise. A simplified fund list or ‘buy list’ should include a range of complementary funds which allow you to build portfolios across the risk spectrum, and which exhibit the properties expected of a high quality investment product. These are few and far between. As an example, only around 30% of the funds we cover globally achieve our highest rating, with an equivalent number achieving the lowest rating. At face value, and with only marketing documents and past performance as your investment guides, the odds are quite low that you will pick winners.

What to expect from your investment adviser when looking to understand funds and simplify choice? We would suggest, in descending order of priority: comprehensive understanding of a wide array of funds, across all managers; strong opinions and good insights – equal ability to critique good and poor funds; up to date on fund, business and industry developments (fund managers change surprisingly often); and independent views.

Building a portfolio for clients

The second part of the investment service involves the construction of portfolios for clients. Advisers predominantly use multiple funds across multiple managers to invest. This is sensible and provides diversification as well as flexibility in delivering an investment outcome. There are a number of ways to approach this, we will just cover two methods: using multi-asset class funds; and using single asset class funds.

Following a multi-asset fund approach is simpler for the adviser: funds are managed within regulatory limits (so fewer compliance checks are needed), and the active allocation decision making is made by the underlying fund managers. With single asset class funds more specialisation is possible, however the compliance is more onerous and also the adviser (and their investment adviser) manages the asset allocation. Single asset class based portfolios have the secondary benefits of being cheaper (sum of the parts is generally cheaper than buying a multi-asset fund), and they can be customised to a particular investment objective if there are no appropriate multi-asset funds available in the market.

In this instance, asset allocation is the key determinant of which route to take – does the adviser have the ability to take this responsibility on-board? In our experience the answer is not simple. We find in the majority of funds that active asset allocation rarely adds value – there are far fewer good ‘asset allocators’ than there are good ‘stock pickers’ in the investment markets, for the reason that asset allocation is the most complex, least predictable function of an asset manager. In this case there is a strong argument for less ‘tactical’ (short term) asset allocation, and more ‘strategic’ (long term) asset allocation.

Once you have decided on your route, the next step is to setup a formal investment process. This includes your Investment Policy document, investment mandates and guidelines, management processes, reporting and compliance. Most of this should be handled by your investment adviser. Importantly, the portfolios or models which you develop should be directly aligned to your own advice process – there should be a clear linkage between the client, the investment guidelines, fund selection and lastly portfolio construction. The investment adviser needs to accommodate your current fund preferences and approach to advice so that they minimise any unnecessary churn in client accounts. In addition, it is rarely the case that there is a ‘one size fits all’ portfolio across advisers so this should be addressed as part of the process.

The process of portfolio construction itself can be complex and technical. What you are aiming to achieve will determine the approach the investment adviser takes in building the portfolio. Prerequisites for your service provider here include: a deep understanding of each fund and how it is expected to perform over time, a clear rationale for using each fund in a portfolio context, the ability to incorporate risk management, and importantly to have a view on how the portfolio should be positioned and be able to implement this well. The tendency here is to rely on quantitative (i.e. statistical – past performance, etc.) methods in building portfolios, however this can provide false comfort unless the qualitative fund understanding is there as well.

The Service Level Agreement

Once you have worked through these various steps you should have a clear idea of the investment element of the investment adviser’s SLA. The various elements of the service level need to be captured in a contract between yourself and your provider – this binds you together and sets out the groundrules for how you and your clients will be serviced. An SLA should cover: the roles and responsibilities of each party, establish the credentials of the service provider, cover confidentiality of information and protection of intellectual property, how fees are charged and how they are paid, what is expected in terms of reporting and face to face meetings, what is expected in terms of supporting evidence (investment policy documents, fund research, etc), and importantly how you are able to terminate the agreement.

In the next article we will cover practical implementation options as well as details around ongoing management of this service within your practice.