The IFA sector continues to be indirectly exposed to conflicts that result in consumers paying higher fees, making them vulnerable to attacks from the industry super funds, who continue to claim moral high ground.
The conflicted sales culture and vertically integrated models of institutionally-owned advisory businesses are well known and documented, and IFAs have worked hard to differentiate themselves from what is perceived to be flawed and conflicted structures.
The major differentiating factor has been the provision of quality, structural advice based on a fee-for-service pricing model. It continues to be the biggest competitive advantage of IFAs over their institutional counterparts (including Industry Super Funds).
Ironically, while IFAs believe they are free of institutional control, most are indirectly exposed to a number of pervasive institutional influences. Once we move beyond strategic advice, the portfolio management component becomes highly reliant on institutionally-controlled business models, the effects of which are considered below.
Shelf-space fees: charges levied by portfolio administration platforms on investment products that act as an effective distribution cost to fund managers. Shelf-space fees form a covert part of the institutional value-chain and lead to: an increase in margin; investment choice control; and cost pressure on fund managers which ultimately flows through to consumers.
Platform-preferred pricing: a discount offered to consumers on investment administration fees as an inducement to use the platform’s vertically integrated investment products. The rationale is to generate higher FUA and FUM growth and to improve institutional profit margins. While reduced costs are always welcome by consumers, conditional discounts demand additional levels of scrutiny along the lines of: are the investment products best of breed? Are they competitively priced? Are they merely manufactured products (passively managed) with active fees? Are they in the clients’ best interest?
Portfolio management functionality: conventional platforms operate under IDPS legislation and require discrete client sign-off before portfolio changes can be made. Additionally, many platforms lack the portfolio functionality required to efficiently make portfolio changes. Consequently, IFAs are exposed to significant operational pressure to implement changes (e.g. replacing investment holdings and/or adjusting the asset allocation) across their client base. It’s common for IFAs to experience protracted lag times before changes are fully implemented. At worst, the operational pressure may result in portfolios becoming inert and sub-optimal. Paradoxically, platform owners are often the winners as inert portfolios tend to stick with the incumbent platform rather than flowing out. Indeed, many (expensive) legacy platforms continue to benefit from “sticky-FUM” due to the high operational cost of moving client portfolios. Best interest duty certainly comes into question.
Approved Product List (APL): or authorised investment menus from which advisers select to construct client portfolios. IFAs generally rely on retail research firms to construct their APLs, with each product requiring an investment grade ranking or equivalent. The retail research model largely derives its revenue by charging the very fund managers it researches, which creates an obvious conflict. Irrespective of the spin applied (i.e. screen for quality first and then invite managers to be researched), the interest of retail researchers is not directly aligned to advisers’ or their clients’ interest. Moreover, the retail research model tends to over-represent active managers and institutional managers with large FUM as such managers have the greatest need for research and are most willing to pay for it. Indeed, it’s common practice for retail researchers to supply fund managers with listings of IFAs that subscribe to their research to promote product sales.
This convention essentially encourages advisers to build portfolios along actively managed product lines, which is not necessarily conducive to constructing optimal portfolios.
In each institutional influence above, IFAs (and their clients) are relegated price takers and the portfolio costs forced upon IFAs are far greater than those of industry super funds; an easy target, indeed.
Disengaging from institutional control
Understandably, IFAs are disengaging from institutional control, but there is some way to go. The most common default for many has been to use direct equities and ETFs and to reject managed funds. Others have by-passed platforms all together. However, while such responses have reduced institutional control, they also introduce other challenges. Direct equity portfolios are often highly concentrated and insufficiently diversified, yet demand more and more time from advisers in order to generate reasonable outcomes. Rigorous monitoring, benchmarking and efficient re-balancing create further challenges. Non platform solutions also face blockages in terms of operational efficiency and scalability. And then there’s the possibility of the regulator re-shuffling the deck-chairs around best interest and perhaps other duties?
Today, IFAs can access platforms that do not charge shelf-space and do not run vertically integrated models. There are platforms that offer IFAs global portfolio management functionality to adjust portfolios efficiently when it’s in their clients’ best interest to do so; and to negotiate pricing directly with fund managers to reduce clients’ portfolio costs. IFAs can also appoint specialist researchers and asset allocators with business models that are directly aligned to client interests. This is all available today.
Some initial heavy lifting is required for IFAs to transition their practices away from institutional control. In return, IFAs can evolve to a new business model which: enables direct alignment with client interests; is built on operational efficiency; has a robust and defensible investment process; and reduces overall portfolio costs. Once done, I suspect the moral high ground claimed by industry super funds will come to an abrupt halt. It then becomes a much fairer contest. In the end, the scales are likely to tilt in favour of IFAs due to the strategic advice piece … as no institution can complete with IFAs in this space.
Stephen Romic is principal of DFS Advisory and DFS Portfolio Solutions
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