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Four pillars of DFM due diligence

2 September 2017

In the first of two articles, Andrew Denham-Davis of Brooks Macdonald looks at processes that can help paraplanners improve due diligence on their discretionary fund manager partners

One of the key motivations for advisory firms deciding to partner with discretionary fund managers (DFMs) is the increase in time and resource that in-sourcing DFM services provides, enabling you to focus on holistic financial planning, client relationship management and life planning.

An additional effect is the creation of increased capacity to take on more clients and scale a business, while gaining access to extensive, dedicated investment management expertise with institutional buying power.
For paraplanners in firms partnered with DFMs, it is critical to conform to the rigorous DFM due diligence requirements set out by the regulator; both at the initial selection process, and on an ongoing basis. This is particularly pertinent with the increase in volume of regulatory pressures, notably new legislation being introduced in January 2018 under MiFID II. While such requirements can put a strain on corporate resources, paraplanners are playing an integral role in managing and conducting the due diligence process.

The opportunity

Research and due diligence should be viewed as an opportunity to provide the best possible outcome for your clients, rather than a burdensome requirement inflicted on firms. An effective due diligence process will ensure that all investment products and services are carefully considered and deemed the optimal solution for clients’ needs and circumstances. An effective process will also reduce the levels of risk that a firm exposes itself to. Indeed, the FCA’s thematic review ‘Assessing suitability’, published in February last year, concluded that poor quality of an advisory firm’s research and due diligence is one of the three root causes of poor client outcomes.

The challenges

By partnering with a DFM, the requirement to undertake due diligence on individual investment selection is relieved, however, you should remain responsible for your clients’ suitability assessment. This means that you must conduct scrupulous due diligence on your panel of DFMs to ensure your clients are receiving the service most suitable to their needs and circumstances. In order to demonstrate client suitability to the regulator, should they decide to review your decisions, you must be able to evidence that you have followed a sound and thorough due diligence process.

There is an almost infinite amount of information publicly available in the market, so sifting through what is most relevant in a structured and consistent manner is vital for the success of your proposition. If not done efficiently, delivering such a process will be time consuming and expensive, meaning there may be substantial gains to be made by improving your process.

Further to this, research suggests that 13% of advisory firms outsource their due diligence process to a third party, but with the right process might it be more cost effective for them to conduct it in-house?
In the second section of this article I will take you through our suggested seven-step approach to DFM due diligence, which will guide you through a proposed end-to-end process. Before you review our suggested seven steps, however, I think it is important that you consider how you implement DFM due diligence more broadly, and the variants that should be considered when assessing DFMs for your client segments.

The four pillars

There are many components to consider when undertaking DFM diligence and what constitutes a reasonable level will differ depending on your firm’s recommendation and the needs of the client segment.
While there are numerous processes you can adopt, we suggest you ensure that the following four pillars are central to your analysis:

1. DFM services available

The range of services offered by your selected DFM(s) must be suitable for your client segment. Services to consider include:

• Bespoke portfolio service
• Model portfolio service (direct and on platform)
• Multi-asset funds
• Other specialist services such as an AIM portfolio service

Details of which services DFMs provide are included in Defaqto’s Matrix data, details of which are accessible from Brooks Macdonald by request.

2. Performance transparency

In order to assess the suitability of a DFM, the DFM must be transparent. Contribution to private client indices, for example, indicates a commitment to performance transparency.
The Asset Risk Consultants PCI was established to provide an insight into the actual client returns being generated by investment managers for their UK discretionary private clients.

3. Back office systems and controls

You must ensure that you are comfortable with the controls and procedures the DFM has established to mitigate the regulatory and business risks arising from the provision of its investment service to private clients.
To support your evaluation, Assessment Reports by threesixty provide a review of such ‘below the waterline’ controls and procedures.

4. Financial strength and risk control

It is your responsibility to ensure that your clients’ money is safe with the DFM, so it is important to confirm the financial strength of your provider to affirm that your clients’ assets will be recoverable, depending on market movements.

Assessment of financial strength can be covered by AKG’s DFM Profile & Financial Strength Reports, specifically designed to meet the information needs of advisers and analysts in assessing the relative strengths of Discretionary Fund Managers (DFMs). Two styles of report are published by AKG – full reports and short reports. A full report is produced for provider companies, which participate and actively contribute to the production of the reports.

If you would like access to any of these independent reports covering Brooks Macdonald, please email [email protected].

Professional Paraplanner