When the going gets tough... the tough get a discretionary fund manager

Investment returns are sluggish at present, and are likely to remain in the single digits for the next two years. With clients grumbling about low returns, many financial advisors are reluctant to propose adding the costs of a discretionary fund manager to the charges clients already pay.

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In fact, many advisors say they are considering reducing their own charges to keep clients loyal in the face of lacklustre returns, so adding an extra 0,2% or so for a discretionary fund manager seems too big an ask. If clients are already paying around 3% for their financial advisor, asset manager and investment platform, and are only getting returns of 5%, they are hurting, goes the argument.

Quite true, but the fact of it is that in a sideways market like this one, the discretionary fund manager is actually in a position to add a huge amount of value, and really help the financial advisor stand out in an overtraded market.

Delivering superior returns sustainably is directly correlated to how well a financial advisor can construct a portfolio. This is less obvious in a bull market, when just about every fund is delivering double-digit returns but, since 2014, the false buoyancy created by quantitative easing has dissipated. It’s now harder to find investments with above-average returns in our market – until, that is, you factor out the big dual-listed rand hedges.

It’s then apparent that South African shares actually do offer good value. But the big, well-known funds struggle to build up significant holdings in them because the companies’ share capital is too small: internal-mandate rules prevent funds from owning too large a proportion of any one company.

In short, to access this value, one needs to look beyond the big funds to the smaller, boutique ones. But with some 1,600 funds in South Africa alone, no financial advisor has the time or expertise to do a proper investigation to find the right fund for a specific portfolio. These boutique funds also tend to carry more operational risk, and so the investigation has to be thorough.

Playing safe isn’t safe at all

So the automatic choice of the big funds that the clients will recognise from TV ads and billboards – you know which they are – is not going to provide the ultimate so necessary in these testing markets. Including various boutique managers alongside these safe bets will be crucial over the next 18-24 months.

Another point about portfolio construction is that each fund has its own investing style, which will perform best in certain phases of the economic cycle. However, the truth is that many people tend to pile into a fund after it has just posted returns in excess of its portfolio benchmark.

The problem here is that Alpha (the active return generated by the manager’s skill over and above the return of the market) is usually or often succeeded by a period of underperformance because the investment climate or economic cycle shifts, and the fund’s investment style is less suited to it.

A discretionary fund manager will be able to provide better forward investment planning that assesses which funds are likely to outperform in the current and future economic conditions, not the past.

Outsourcing asset consulting

Finally, proposed regulatory changes – Treating Customers Fairly and Retail Distribution Review – will make it mandatory anyway for financial advisors to do the research across all funds in order to advise clients properly. When these come into force, planners will either need to become discretionary fund managers themselves – an option that is not possible for most, or enter into a partnership with an asset consultancy firm. For many advisors, it makes excellent sense to outsource asset consulting to the discretionary fund manager.

From where I sit, in fact, paying 0,2% looks cheap for a professional research service that includes the right tools to help construct a customised portfolio aligned with a client’s “risk budget”. As I said, this capability will set the financial advisor apart, and will also keep him or her on the right side of the law. Clients will see it as a significant value-add, too – especially when they start comparing their returns with those their friends are getting.

A final word of advice: discretionary fund managers aren’t all equal. Make sure you deal with one that has a track record of managing third-party collective investment schemes on behalf of clients, and so has a performance history that is public and verifiable.