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Discretionary fund managers add independence in wealth management

Financial advisors are going back to core competencies and leaving asset picking to the professionals.

Looming regulation related to the distribution of financial products and the provision of financial advice has seen the role of discretionary fund managers (DFMs) becoming increasingly important.

The DFM industry has seen rapid growth over the last few years, both in terms of assets under advisory and the number of DFMs in the market, says Stephen Backhouse, who is responsible for strategic relationships at investment platform INN8.

DFMs are independent investment experts who make investment decisions on behalf of financial advisors who mandate them to act for clients.

Backhouse says their recent rise is partly due to impending Retail Distribution Review (RDR) legislation, which will place greater onus on advisors to make more informed investment decisions.

RDR and Treating Customers Fairly (TCF) regulations, which are proposed in South Africa and already operational in countries like the UK, have forced financial advisors to revisit what they do and what their core competency is – which is giving financial advice and looking after customers.

“Previously many financial advisors saw themselves as fund pickers,” says Backhouse. “But now they are increasingly saying that their role is to look after clients, and they are outsourcing the picking of funds to someone else.”

Many fund managers would put client investments in an investment firm they preferred, and there was limited diversity. Investment professionals saw a gap in the market for independent and professional advice.

Within the last few years, a number of key DFM players have emerged, including PortfolioMetrix, Fundhouse, Morningstar, Analytics and Boutique Investment Partners (BIP).

Financial advisors sign up with a DFM, which then puts a solution together for the advisor based on its understanding of the advisor’s practice, view on risk and other criteria.

“This creates a layer of independence,” says Backhouse. “DFMs act as the voice of the market, and they can challenge the thinking of some of the bigger corporates on issues like fees, for example, which a lone advisor wouldn’t be able to do.”

DFMs are not likely to take over the role of financial advisors as they generally do not want a relationship with the individual clients, although in the UK, some DFMs are starting to put direct models in place. “Their big value is a personalised service to the advisor,” says Backhouse. “This does add a layer of cost, but DFMs are seen as a value-add.”

This creates a challenge for financial advisors signing up clients. “One of the challenges for DFMs and financial advisors is that markets haven’t grown in the last three years. Over that time, medium risk balanced funds have done less than 6% and investors have seen costs go up and performance drop off.

“Yet DFMs have grown when markets have been flat. The good DFMs are not about performance, but about meeting goals and they help the advisor to track goals matched to client needs.”

Backhouse says DFMs have very professional independent teams which are flexible to advisors’ and partners’ needs, and are happy to do some additional work to help advisors. At larger fund managers, this is more difficult. “DFMs don’t have the bureaucracy and legacy, so their service offering to clients is phenomenal.” This can include advice to advisor firms on their own business processes and risk management, portfolio construction for the advisor, due diligence on portfolios, and creating the right blend of portfolios.

Some have a managed model solution, where they have a view and build a portfolio based on that view, while others do specialised or bespoke model portfolios for advisor firms or at individual client level.

It is estimated that 25% of wealth managers are using DFM services, up from 5% or less just a few years ago. In the UK it is now close to 40% and growing. “This talks to the potential growth of this industry in South Africa,” Backhouse says. “Our estimate is that there are over 40 DFMs in South Africa, with about six dominant players, and assets under management estimated to be over R230 billion.”

On the face of it, the core offering of DFMs seem very similar – they take on the portfolio management selection responsibility and the buying and selling decisions, leaving the financial advisor to focus on advising and servicing clients.

All have similar value propositions, but in the background, they are quite different, says Backhouse. PortfolioMetrix, for example, is big on tech, and has sophisticated tools that produce comprehensive investment plans. Firms like Fundhouse, on the other hand, are big on research. Some have specific client portals with tools and reports that advisors can use while others tailor-make solutions to the advisor’s business model. “A DFM’s investment style and the way they view risk also differs, as well as the investment vehicles they use – model portfolios or fund of funds, or both,” says Backhouse.

While growth in the sector has been rapid, DFMs do face some challenges. “The bigger they get, the more their perceived independence will start getting challenged –and there is a risk that the bigger their partner or client base gets, the more chance there is that they will lose focus and this will provide opportunities for smaller DFMs to come in.

“The biggest challenge is that clients pay an extra fee for the service, and in a low-return environment, this issue has created quite a few questions.”

However, DFMs have been critical in improving the reputation of the advice industry as they have strong values about client return and they help advisors create better service to clients. In the UK, DFMs have also been responsible for driving down fund manager fees as they are able to exert greater influence than individual clients given the amount of assets under management they have.

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