Centralised Investment Propositions (CIPs) – Part 3: Outsourced

As we mentioned in the previous piece there is a commercial rationale behind the many outsourced CIPs available. This number is still constantly growing, no doubt fuelled by adviser firms looking to de-risk their businesses with the outsourced companies believing they can either add value, reduce cost or remove the hard work of creating and rebalancing portfolio ranges on platforms. It is latterly the platform providers themselves throwing their hats into the ring with several becoming MPS providers.

At outset, an important decision to take is that of an Agent as Client model versus that of Reliance on Others. The PFS good practice guide on this here and is a recommended read, as is this. These documents provide all one would need to make the right decision for their business.

Remember to “get under the bonnet” of the DFM. Conduct proper due diligence at outset and set annual reviews. Most DFMs provide their own DD packs, so make sure you receive this and rather than just file it, probe a little further to demonstrate you have not just completed a tick box exercise. If they use their own internal methodology on any aspect of the creation of models, make sure it is understood, as you may need to explain your choice of DFM at some future point. Many have their own iterations on a model portfolio theory, which produces the models along the “efficient frontier”.

Do not be afraid to ask for a sample fund research notes or the terms of reference for the investment committee. Check what permitted concentration level of a fund is set within a portfolio, and then see whether this was ever breached. Ask if there have been liquidity issues requiring more than one day’s trading, or the imposition of dilution levies. If so were these issues clear when engaging with the fund manager at outset, and then, how did they ensure all clients were treated equally if platforms were being rebalanced on differing days.

Portfolio managers sometimes use their own funds. These can be an existing fund range or where the manager creates a mirror/overlay fund . For the former, where the provider uses their own funds, how is the conflict of interest managed? What DD is performed on the fund and does it really undergo the same rigour as external funds within the portfolio? For mirror/overlay funds being used for “operational” purposes, ensure that total costings are clearly understood. A mirror/overlay fund is where the DFM creates a unitised fund to include as part of their own portfolios where this makes sense for clients.

The benefits of these include:

• Time in the market – even rebalances on platforms can take clients out for weeks at a time and where rebalances are up to 4/5 times per annum that is a lot of time to be out in volatile times. A rebalance can be performed in this fund to put the entire portfolio where the DFM wants it. As an example a 2% overweight in European equities could be achieved by going 4% overweight in the fund, thus the overall portfolio is correct.
• Fund rebates – the DFM will negotiate fund rebates and feed these back into the client portfolios via additional units in that OEIC. A good negotiator will ensure a rebate on an aggregated amount, knowing that the client has units of the fund on the platform as well as in the OEIC the manager can see.
• Access to fledgling funds not yet available on platforms (all platforms needed)
• Use of ETFs and Institutional share classes
• Reduction in CGT as transactions inside a fund (upon rebalance) are tax free whereas on platform in the model will trigger CGT events.
• Lastly, operational ease for the DFM, but that is not strictly a client advantage although access to funds is much less restricted.

The perceived disadvantages considered were:

• Additional cost of managing the new fund. Is the DFM double-dipping, or only charging on one aspect?
• Does the rebate cover this cost?

Some DFMs waive the portfolio management fee if taking a fund charge whereas others have a fund management fee plus the portfolio fee. It isn’t just a simple case of comparing these. The larger portfolio managers will frequently negotiate rebates which then feed back to the clients, so detailed scrutiny is required.

The benefits of a mirror/overlay fund are not just operational for the portfolio provider. The client will benefit from increased time in the markets as a rebalance can be effected in the fund for the entire portfolio in a day rather than what could be two weeks on platform. Then there is also the ability to access institutional funds, fledgling funds etc across all platforms plus the added benefit of CGT reduction. (rebalancing on platform will trigger CGT events whereas within a fund it does not).

Also ensure it is understood how DFMs benchmark their models, whether this is  industry standard (and relevant), or internal (and if so, why?)? Comparing performance of DFMs can be tricky, not just because the comparative models are slightly different, but also where the benchmarks used are vastly different. Remember that the Agent as Client model has the IFA as being ultimately responsible for the investment decisions as the “Professional Client” of the DFM.

When looking at DFMs consider also their rebalancing methodology. Evidence supports ad-hoc evidence-based rebalancing over date driven rebalancing. There must also be thresholds at which rebalances must happen or else models will drift outside of their chosen risk profile. Rebalancing takes clients out of the market. Even on platform, rebalancing can take up to two weeks (platform dependent of course) by the time all trades within a portfolio have been settled. Too frequent a rebalance can thus also lead to a performance drag, as can too infrequent… A tricky balancing (pun intended!) act for the DFM. Does the DFM have a tendency to tinker at the edges “just to show they are doing something”? Doing nothing is also an active decision.

There will be times an investment decision is made which subsequently goes against the investor, but as long as the decision was made for the right reasons this should not be held against the DFM. Unforeseen events happen and if the manager can show that the reasoning was sound at the time then they should be retained. The below grid demonstrates this simply:

Sometimes a good outcome can come from a poor investment decision, and that is just pure luck. How many times can they be lucky? Stick to robust investment principles!

Outsourcing brings more than just investment expertise. An outsourced offering automatically brings scale, breadth of styles, reach on platforms, track record, and being externally rated (Defaqto, Morningstar, etc). In more detail:

• Scale: the purchasing power of a DFM will lead to improved fund share-class availability, including institutional funds. In addition, some fund houses will offer rebates, which are then passed back on to the investor. Scale, of course, also in the size of the investment research teams all the way through to the operational teams preforming the rebalances.
• Breadth of styles: do you want to follow a global or a UK bias model? DFMs will have a broad range of styles from actively manged to tracker models, plus ESG, Decumulation and Income (and possibly more).
• Reach on platforms: the larger the DFM the more platforms will want them on their services. It is not uncommon to see the larger players on 20+ platforms.
• Track record: this is a great advantage at launch as it is hard to get clients to take on board an unknown. The outsourced market is mature now so track record is easily obtained.
• Externally rated is self-explanatory…

All of the above should also be considered if the adviser firm is creating their own in-house offering and the complexity covered above may well be why many have decided that it is wise to stick to advising and letting others make the investment decisions (plus be responsible for them).

Introducing an external DFM/Portfolio Manager does however also add another layer to the CIP, which will come at a cost. The costs are coming down as more competitors enter the market, but as always cost is not a sole reason for being selected. I think all would agree that ultimately the reason for choosing an outsourced solution is for the additional and professional service provided as an extension of the IFAs services to the client. It really is no different to an introduction to either a solicitor or an accountant to provide a professional service as an extension to the IFA offering.