Fears grow over advisers’ investment due diligence

Concerns are being raised advisers are not carrying out robust due diligence when it comes to fund selection, with insufficient attention paid to asset management charges.

Research by Fund Strategy sister publication Money Marketing suggests many advisers carry out their investment due diligence themselves, but the findings also point to an over-reliance on rating agencies and marketing material from fund groups.

At the same time, advisers and investors can face an uphill struggle when it comes to finding meaningful data with which to assess funds.

With the FCA stepping up scrutiny of fund management, Money Marketing has examined how advisers carry out investment due diligence and the overall role advice firms have to play in competition between asset managers.

Costs are not the priority

Our research looked at attitudes towards investment outsourcing and fund selection based on 204 adviser respondents.

Of those, 69 per cent are picking funds themselves, although some say they are outsourcing investment choices to discretionary fund managers. This may reflect some firms adopting a mix of both approaches, through the use of investment committees or in-house analysts.

Advisers were asked to rank the criteria they use when it comes to fund selection on a scale of one to five, with one being “not at all important” and five being “very important”.

Investment processes came out as the most important criteria for 42 per cent of respondents. A third of advisers surveyed said performance track record was important, while the cost of investment management was ranked as important by 30 per cent of advisers. Five advisers rated fees as “not at all important”.

Independent regulatory consultant Richard Hobbs says while advisers are being “objective” if they are focusing on investment processes, he argues costs need to play a more prominent role.

Hobbs says: “If a fund manager you are working with is a nightmare, your costs go up and then you go somewhere else.

“I don’t think advisers would be surprised by these results but the regulator might confirm this is the case and conclude the industry works for itself and not for customers.”

The Financial Inclusion Centre co-director Mick McAteer says costs are generally the sole element advisers can control as opposed to “the myth of past performance”.

He says: “The thing advisers can control is fees. This is where they can have a significant influence. Evidence shows it is not possible and not worth it to predict future returns based on past performance as this is something out of their control.”

But Investment Quorum chief executive Lee Robertson says: “If a fund is fit for purpose, delivers alpha and sits well within the desired client asset allocation and risk tolerances when blended within a portfolio then the charges, while important, are secondary to the fund delivering what it is meant to do via process and performance.”

Earlier this month the FCA published a series of “sector views” on the financial services market, setting out the key risks it has identified as the areas it wants to focus on. These included a renewed focus on advisers and investment suitability.

The FCA said some firms might not be providing suitable, consistent investment advice and attributed this to possible conflicts of interest or insufficient competence.

Going the extra mile

Gbi2 managing director Graham Bentley argues many advisers “don’t get that far” when looking at investment processes.

Bentley says advisers start by looking at fund managers’ track record but claims that may not be followed through, and argues many advisers pick a fund without meeting a manager.

He also points out some advisers consider factors such as portfolio turnover or active share (the proportion of stocks held that differ from the benchmark) as important to their research. But he says most of this data is not always available to them.

But Apfa director general Chris Hannant argues it is “artificial” to say advisers look at one aspect over another in their fund due diligence.

He says: “Advisers look at different aspects when they pick funds. There are thousands of funds out there, they can’t meet all of the fund managers. It is about filtering processes to try to get a sense of the fund manager’s approach.

“Then you would expect them to continue researching and digging on particular funds if that is what your client wants. You need some information tools to narrow down research.”

‘Shallow research’

In our research, almost half of advisers said they use rating agencies to get their information on managers and funds.

Respondents also cite asset managers’ websites, marketing meetings and “word of mouth” as their research sources.

Bentley says some advisers are doing “shallow research” as they are using performance data analysis and are not actually looking at research.

He says: “Due diligence is not just done by looking at analytics. Understanding why something is underperforming is important. A lot of people that buy absolute return, for example, wouldn’t know how to explain it.”

In terms of other sources, advisers use fund data firms such as FE Analytics and support services firms.

Only 10 respondents have an in-house investment committee, and just eight advisers say they personally meet fund managers.

One respondent said they used “knowledge gained from model portfolios” in order to do due diligence.

Hobbs says: “The reasons why advisers use rating agencies is because they provide a vast amount of information. But advisers are just as sceptical as the FCA on the information they are receiving from rating agencies. Advisers are good at spotting conflicts of interest.”

In February 2016, the FCA assessed 13 advice firms to review how they conduct research on products and services as part of a thematic review.

While the FCA found good practice overall, it stated firms should consider whether they can rely on the information supplied by the provider, including marketing material.

It said: “Firms can rely on factual information provided by other EEA-regulated firms as part of their research and due diligence process, for example, the asset allocation. However, they should not rely on the provider’s opinion, for example, on the investment’s risk level.”

The FCA added sometimes advises “did not seek to understand or challenge their own inappropriate bias towards products, services or providers”.

Roberston says rating agencies are helpful but takes them “with a pinch of salt” as many appear to rate funds within groups which subscribe to their services.

But he says those rating agencies with wide fund and group coverage are a good starting point.

Equilibrium Asset Management partner and investment manager Mike Deverell will often invest into relatively new funds that would not qualify for a rating and normally does both quantitative and qualitative research, using FE initially.

Deverell looks specifically for consistent performance, consistent alpha, and includes factors such as active share.

The firm also looks at how funds have done in rising and falling markets. Once it identifies a potential fund it asks for a due diligence questionnaire to be completed and then they meet the fund manager.

Deverell says: “This means we sometimes buy funds that have gone through a bad patch because they were not suited to the past market environment, but we think they will suit the environment in future.”

Passive best practice

Money Marketing also asked advisers about how they are allocating to passives, given the FCA’s more positive slant to passives set out in its interim asset management study in November.

Some 15 per cent are not recommending passives at all. Around 25 per cent allocate between 5 and 15 per cent to passives across their client bank, while nearly a third of respondents allocate between 20 to 35 per cent, and nearly 20 per cent allocate 50 per cent or more of their clients to passives.

McAteer argues if more advisers were to recommend passives they would avoid potential biases, such as those from rating agencies.

He says: “It’s really difficult to justify why advisers still recommend active funds. Best practice  would be agreeing to a long-term strategy, look at the best service and pick passive funds.

“Evidence shows there’s no point in picking an expensive fund since most active funds are not outperforming.”

The Financial Inclusion Centre wants the regulator to introduce an equivalent of the RU64 rule for advisers to recommend a passive fund over an active fund if they have similar characteristics.

The RU64 rule required an adviser to justify why the personal pension they were recommending is at least as suitable as a stakeholder pension.

But others argue passive funds are not the solution to make due diligence less onerous.

Tilney Group managing director Jason Hollands believes smaller firms or financial planners are avoiding doing investment themselves and are buying more passives or multi-asset funds because they recognise fund picking is a different skill set.

He says: “There’s no doubt there are very high quality firms that do due diligence seriously, but also some that buy off-the-shelf multi-asset solutions or others picking passives because they don’t have the same due diligence process as active funds.

“But not every asset class can be indexed. It could be convenient for advisers although it is not a panacea.”

Money Marketing found 89 per cent of respondents have not recommended more passives following the FCA’s interim asset management report.

One adviser says: “In the current evolving market investors are not willing to invest in active managed funds,” while another says it would be “unwise” to exclude passive selection without “good reason”.

Expert view

Threesixty managing director Phil Young


Fund selection and research remains very fragmented across advisers, far more so than product and platform research which tends to follow a more familiar structure. The sheer number of funds, and the complexity over researching them means it’s not surprising advisers use research agencies to narrow choice down.

The danger is the amount of influence that places on research houses and the business models it drives. Advisers are effectively outsourcing a significant element of quantitative analysis and almost all the qualitative analysis to research houses and it’s really important they know how they operate.

The brand of the research house seems very trusted even if the brand of the fund manager isn’t that important according to the survey.