Key considerations when choosing a discretionary fund manager

In our first article¹ on discretionary fund managers (DFMs), we discussed financial advisors’ uptake of the services of DFMs and the potential for growth in the DFM market. In this article, we take a closer look at fees and share some observations on the investment philosophies of DFMs as well as other interesting characteristics of DFM model portfolios. We trust this article is useful in helping you, the advisor, to assess a DFM’s value proposition.

Types of discretionary managers

With well over a thousand model portfolios administered on the Ninety One Investment Platform, it is important to differentiate between the different types of Category 2 business models. We split the landscape into the following three broad categories:

1. Independent DFMs not aligned to any advisor or platform/asset manager;
2. In-house DFMs where the advisor practice has sufficient scale to enable it to staff an in-house DFM; and
3. Advisor-run model portfolios where the advisor has the Cat 2 licence.

The NMG survey raised some key issues which prompted us to analyse our data on the Ninety One Investment Platform as it relates to DFMs and model portfolios.

The elephant in the room – fees

In our previous article, we showed that the primary reason cited by advisors who do not use a DFM was the perception that they are too expensive.

Figure 1: Reasons for not using a DFM

Source: NMG Retail Wealth Survey, 2020.

The value chain and how its broken up is a popular topic, particularly when it comes to fee compression debates (provided it is not your fee being compressed). DFMs, in one form or another, have been part of the landscape for many years but only became mainstream in the last five years or so. This means that in the main they missed a large part of the fee pressure that the industry went through over the last 10-15 years. Platforms bore the brunt of the fee compression, with fees halving. Fund managers experienced some compression, but it was mostly at the margin and generally reserved for institutional investors. While some of this institutional pricing has found its way into the multi-manager and DFM landscape, the NMG research shows that the total investment charge (DFM plus asset manager) has remained largely unchanged over the last few years.

Figure 2: The investment value chain

Source: NMG Retail Wealth Survey, 2020.

For comparison, we looked at the fees charged by eight independent DFMs on the Ninety One Investment Platform. We assessed 540 domestic model portfolios and found that fees ranged from 18-32 basis points (bps) with an average of 25bps, which corresponds to the NMG survey of 2020. The high dispersion in the range of fees charged may in part be due to the fact that in some business models DFMs pass on part of the model portfolio fee to the advisor who operates under the Cat 2 supervision of the DFM. Effectively, the advisor provides some of the services associated with running the model portfolio.

Figure 3: A high dispersion in fees charged

Source: Ninety One Investment Platform, as at 30 June 2021.

Building blocks, asset allocation or somewhere in between?

When it comes to choosing a DFM, it is key to understand a DFM’s investment philosophy and how it goes about setting and achieving investment objectives. A common point of differentiation between DFMs is the extent to which the asset allocation decision is left to the underlying asset managers. DFMs who follow the building block approach, tend to set a strategic asset allocation benchmark and populate each asset class with managers who specialise in that bucket. The DFM then tilts the allocation to a specific asset class, based on its outlook for that asset class. At the other extreme, the DFM may populate the model by using mostly multi-asset funds, leaving the asset allocation decision largely to the underlying managers. Some DFMs fall in the middle and use a combination of building blocks and multi-asset funds. They may or may not tilt the exposure to a specific asset class.

In our sample of 8 DFMs, at the aggregate level, SA multi-asset funds (high, medium, low equity and flexible) featured in just over 50% of the 540 model portfolios analysed. One could easily draw the conclusion that a large proportion of model portfolios rely on the asset manager to effect changes to asset allocation. However, in many of the models, exposure to these funds was small (less than 10%), meaning that the effect on overall asset allocation would be marginal.

Measured by assets under management, they are also the largest sector with 27% of assets invested in funds from these sectors. However, our analysis shows that this exposure is largely associated with those DFMs that follow an asset allocation approach. This implies that a large part of the tactical asset allocation call resides with the DFM. Given the importance of asset allocation in achieving investment outcomes, advisors should interrogate how the asset allocation decision is made. Importantly, the DFM should be able to demonstrate through detailed attribution the impact of such a decision. Where the decision is left to the asset manager, advisors should have a clear understanding of how changes in asset allocation may impact the model’s ability to achieve its investment objective.

Figure 4: Sector usage

Source: Ninety One Investment Platform, as at 30 June 2021.

Figure 5: Individual DFMs’ sector preference across all models

Source: Ninety One Investment Platform, as at 30 June 2021.

Diversification – how many managers is enough?

In our August edition of Advisor Impact,² we showed how diversification benefits (as measured by a reduction in volatility) is limited beyond a handful of managers (4-5). However, constructing a portfolio to meet a specific investment objective is not just about reducing volatility: how a portfolio is optimised to achieve this goal, may necessitate additional managers.

This does not imply that there is an optimal number of managers that should be used, but rather that for every manager included, the marginal benefit derived from the additional manager most likely decreases. What is more important is that a DFM should be able to clearly articulate why a particular manager is included in a portfolio and the effect that this addition has on the overall portfolio’s characteristics.

While the number of funds used ranges between 2 and 15, half of the models employ between 6 and 10 funds per model with a median of 8.

What is interesting is that the high dispersion in the number of funds used is prevalent across all DFMs. The data shows that the primary reason for the dispersion relates to the type of investment mandate of the model. Typically, the income-orientated models tend to have significantly fewer funds (2-5) while the growth-orientated models have the greatest dispersion (4-15).

There appears to be little correlation between the number of funds used and the number of managers included to build models. On average, the number of managers used in a DFM across all their models is 13, with a maximum of 16 and a minimum of 9.

Figure 6: Little correlation between number of funds and managers used

Source: Ninety One Investment Platform, as at 30 June 2021.

In total, 23 managers are used across all 8 DFMs; however, manager concentration is high with the top 5 managers accounting for 70% of the assets held in DFM model portfolios.

Passive investing trends

On average, independent DFMs’ overall exposure to passive investments is 18%. Once again though there is significant variability in the use of passives ranging from 25% to 0%. Of more interest, however, is that independent DFMs use significantly more passive funds when compared to advisor-run models (8%) and advisor assets held outside of models (5%). When assessing DFMs, advisors should ascertain under what circumstances passives will be used in a portfolio. Are they used to optimise the portfolio or to bring down the overall cost of the portfolio? While passive investments can be used to control costs, it is important that the investment merits stack up against using an actively managed portfolio.

Figure 7: Significant variability in the use of passives

Source: Ninety One Investment Platform, as at 30 June 2021.

Takeaways

Our analysis shows that DFMs follow different investment philosophies to build portfolios. Determining the ‘best’ investment philosophy may be tricky. Advisors should rather ensure that the DFM’s investment approach resonates with their own investment beliefs and that ultimately, it will assist in delivering the right outcome for clients. It is important not to look at fees in isolation. Lower costs do not necessarily result in better investment outcomes.

We trust that the analysis we have presented here will help advisors to ask the right questions when evaluating a DFM’s value proposition.

During the due diligence process, advisors should ensure that the DFM is able to clearly articulate its investment philosophy as it relates to asset allocation and manager selection. Pertinent questions include: Who is ultimately responsible for the asset allocation decision? How is this implemented? Where a building block approach is followed, advisors need to determine how the strategic asset allocation benchmarks are optimised and how often the process is reviewed. If a tactical asset allocation overlay is implemented, advisors need to ask: Who is responsible for this? How is it implemented and measured?

In terms of manager selection, advisors should ascertain how the DFM goes about choosing managers; the analytical tools used to assess manager skill and perform ongoing attribution; the frequency of manager updates; and under what circumstances passives are used in place of an active manager. Ultimately, the advisor should be comfortable that the investment outcomes of the portfolios are clearly articulated, and that the process and philosophy followed by the DFM will result in the desired outcome.

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¹ The DFM landscape
² Thoughts on building global portfolios