Round pegs, round holes or something better? A regulatory proposal for advice

Anyone who knows me will tell you this is something I’ve been banging on about for years. Although I think we could go a step further. How about, in the spirit of best interests, instead of round pegs, round holes, we aim to make the peg the same shape as the individual client? Because let’s be honest, we wouldn’t need to be having this conversation if clients were all the same shape.

I welcome and support the FSC’s white paper. To add another angle to the conversation, I believe there’s an area that could be enhanced to get us to where I’m talking about. That’s investment propositions based on the use of professionally managed model portfolios or investment strategies.

An estimated 80 per cent of advisers use professionally managed model portfolios or investment strategies as the basis for implementing an investment program for clients. That they are so widely adopted makes sense. They can reduce the time, effort and cost of investment research, hence lowering the cost of advice. In addition, when subscribed to as an ongoing service, they can bring a level of dynamism and value-add to clients. A big part of this is that model portfolio-based propositions can be extended, personalised and tweaked for each client (a process they call overlay in the US), because, as discussed, clients are not all the same shape.

In terms of their regulation, I believe there’s a golden opportunity to create a client/adviser/licensee/regulator win-win-win-win here. By reframing investments as a service to clients, as opposed to the friction of seeking to match one-size-fits-all pegs (products) into a client’s risk profile and needs, an adviser would be in a better position to fit their advice to the shape and size of that client.

Generally, there are three ways to implement model portfolio or set investment strategies in Australia today:

• Advisory, where an adviser reviews and rebalances a client’s portfolio, providing a proposal for their approval. The upsides: explicit client consent, ability to tweak for each client, and supports an ongoing client to adviser relationship. The downsides are the time and costs associated with delivering this approach.
• Separately managed account (SMA), where an external product provider rebalances client portfolios to model portfolios. The upside is there’s little to no ongoing work for the adviser, the downside is the client may question why they’re paying the adviser for the service, asking where’s the value-add from the relationship. There’s also design and distribution obligations and the cost of the SMA product and associated platform(s).
• Managed discretionary account (MDA), where an adviser, licensee or third party rebalances and adjusts client portfolios without the need for any specific consent from the client. Like an SMA, the upside is little to no ongoing work for the adviser apart from annual confirmations to continue. The downsides, albeit to a lesser extent than with SMAs, are again that should the MDA be operated by a third party, the ongoing value-add may be questioned and the potential additional costs.

I propose a fourth option:

• Reframing model portfolios or set investment strategies as a component of client service and using them as a foundation to meet the needs of individual clients.

In other words, instead of outsourcing to external product providers, some appropriately equipped advisers do the portfolio management in-house using professionally managed model portfolios and investment strategies that they have tailored to their clients’ risk profiles and investing needs. Bests interest in a contained service scope.

Advisers are ideally positioned to deliver this. They know their clients better than anyone because they have the advantage of meeting with them face to face and often helping with more pressing strategic and life planning activities. Unlike external product providers, this personalised connection enables them to have deep insight into their clients’ wants and needs, including how they prefer to receive information and be involved in the decision-making process. This is a key value-add for clients.

On determining the right model portfolio or investment strategy for the client, adjusted with some client-specific rules, preferences or constraints, the main issue from a client experience perspective would no longer be what external product to put them into, but simply whether they want to be consulted for changes to the portfolio or not. If the client wants consultation, this can be a service offering with associated charges. If they don’t, they can simply give or take back at any time the adviser authority to make changes on their behalf within the predefined limited scope.

To build on the FSC’s recommendations, this would require the introduction of a regulatory construct that supported and empowered advisers to deliver a service- oriented investment proposition that can efficiently and with scale match investment securities and products to clients, as opposed to working within construct of the past of matching clients to products or product structures.

In current regulatory speak this could mean the introduction of relief (or reintroduction given the limited MDA relief of the past) to allow advisers to make adjustments to client portfolios to reflect an agreed investment strategy (i.e. as part of an agreed statement of advice) without explicit client consent and without triggering RG179 (MDAs), which focusses on “the discretion to make investments without prior reference to the client for each transaction”. Perhaps there may need to be some qualifiers around disclosure or lack of conflicts in the investment strategies or model portfolios, but isn’t that already in place?

Consider this:

• The client wins as they get an investment program overseen and tailored to their specific situation by someone they know and trust, and most likely at a lower cost if the adviser has less workload to implement such
• The adviser wins as they can – if they wish to – deliver a model portfolio or investment strategy-based service efficiently and with scale through the use of supporting platforms and technologies, bringing additional value and lower costs to clients
• The licensee wins as they can help advisers with easy-to-implement investment programs that start with professionally managed model portfolios and investment strategies
• The regulator (and again licensee) wins as the process can be simpler to oversee and simpler to audit. They could use technology to take a leading and proactive role in monitoring compliance
• Even product providers win as those who have products that form part of client-centric model portfolio-based investment strategies are likely to receive higher inflows.

So who loses? My guess is those fighting to match clients to products and call it advice, essentially those trying to fit square pegs into round holes. But isn’t the essence of the design and distribution obligations and other regulatory themes in this industry supposed to minimise that anyway? I’m not referring to a specific company or type of product provider here. It’s actors putting up barriers to maintain the status quo at the cost of delivering client-centric advice. Because as KPMG’s analysis in the FSC’s white paper shows, perpetuating the current environment is no longer sustainable and potentially threatens all advice propositions.

So is it time to remove the layers of red tape associated with trying to match products to clients and use the opportunity the FSC has created to go even further? As an industry can we challenge our thinking about ways to simultaneously reduce the costs of advice, improve advice business efficiency and create solutions focussed on the individual client? My sense is that reframing model portfolios or investment strategies as a component of client service and using them as a foundation to meet the needs of individual clients would be a practical and realistic way to achieve all three.

Stuart Holdsworth, chief executive and founder, Financial Simplicity

Neil Griffiths

Neil is the Deputy Editor of the wealth titles, including ifa and InvestorDaily.

Neil is also the host of the ifa show podcast.