The Discretionary Fund Management (DFM) industry in South Africa currently finds itself at an interesting juncture. It is now approximately 10-15 years old and the latest DFM survey conducted by the Collaborative Exchange puts total assets managed by DFMs between approximately R400-R450 billion. This is significant growth from 2014 when DFM assets were estimated to be around R40 billion.  This raises the question as to what lies ahead for the DFM market and how the industry can take itself to the next level? Consolidation of DFMs must be on the cards, bizarrely we still grapple with transparency issues and lastly, the impact of cost pressures may be at the detriment of investors going forward. I briefly discuss each of these points.

Inevitable consolidation  

Building a successful DFM is not easy. Investment performance, total asset size and distribution footprint are crucial factors in building a sustainable investment business. I am not sure that all DFMs are at the required level when it comes to any of these factors. While there is definitely space for boutique DFMs with differentiated value propositions, some LISPs are reporting up to 60 DFMs running money on their platforms. With approximately 70%-80% of the total DFM assets being concentrated within the largest 5 or 6 DFMs, it will be very difficult for smaller DFMs to sustain themselves indefinitely on what is generally quite thin margins. This is worrisome in that more competition can only be healthy for the industry and keep the big players on their toes.

Consolidation can happen in many shapes and forms, from strategic partnerships to full corporate deals. But no matter how consolidation takes place, it seems highly likely that over the next 5-10 years, there will be fewer names in the industry. With large institutional players moving into the market, DFM value propositions will come under tremendous pressure, particularly around the ability to access more competitive fee rates with asset managers. 

Transparency is key to raising the game

Surely an adviser should be able to make an informed choice when partnering with a DFM?  Unfortunately, despite the maturity of the DFM industry, major transparency issues remain. It seems difficult to believe.

Investment performance – ‘show us the numbers’

The drive for transparency in the investment performance of DFMs is crucial to the integrity of the industry – because not all DFMs have an actual, established track record of managing money. Some DFMs have pushed back and even questioned the motivations for pushing the performance transparency agenda. I have heard some interesting comments from my peers, the best being, “it’s an agenda pushed by asset managers”. The real question is, why the push back? Fortunately, our business has been managing client money for more than two decades with a published track record in our unit trust funds that is freely available for all to see. Most DFMs have only managed model portfolios on LISPs and verifying the history of these track records can prove difficult, although not impossible. I would therefore implore that the DFM industry come together to resolve this. Surely increased transparency can only lead to better client outcomes?

Becoming more institutionalised requires opening up

When you scratch the surface, it is not surprising to find that not all DFMs have the same investment and operational capabilities – this can and probably will result in performance differences over time. Investment pedigree and team size will eventually become more important as DFM selection criteria for advisers – there are many DFMs with only one or two individuals responsible for managing solutions. With more than 1 500 local funds and tens of thousands of global funds, performing fund research and portfolio construction at an acceptable standard is very difficult. Fortunately at Liberty DFM, we have an investment team of 20 plus in JHB, CT, Jersey and London, along with global fund research partnerships.

Participating in performance surveys can only assist the adviserThere are still DFMs that are reluctant to participate in performance surveys. This is particularly important since the number of DFM choices for advisers has exploded over the past 3-5 years as mentioned above. Just as when selecting a fund manager, DFMs should be put under the same scrutiny of due diligence, including both qualitative aspects such as investment philosophy, process and team, as well as quantitative research of which understanding performance is crucial.

We have a curious scenario in SA where the same DFMs that conduct due diligence on asset managers and expect transparent performance from them, are not willing to be transparent themselves.

Wrong approach for the wrong reasons  

This brings me to the last point and perhaps most controversial, the impact of low DFM margins and fee pressures on portfolio construction approaches. We are seeing more DFMs moving towards a specialist building-block approach – using asset class building blocks such as local and global equity funds, local and global bond funds, local and global property funds etc – for portfolio construction. This need not be of concern since many multi-managers or DFM teams should be able to use this approach – and most experienced outfits do, both locally and globally. But in order to use this approach, the DFM investment team should have the skill and expertise to not only develop long term strategic asset allocations (SAAs) but also shorter-term tactical asset allocation views – and then have the ability to execute on these views.

The trend that we see developing is that many DFMs without the necessary asset allocation capabilities are turning to building block solutions, not because they think they have the required asset allocation skill and experience to do so, but rather because these building blocks are a lot cheaper to manage than multi asset (balanced) funds. Remember that with balanced funds, all the investment decisions are outsourced to the underlying funds/managers.

The overall cost pressure means that they have to find ways to build client portfolios at lower costs in order to justify the DFM charge. There is a cost difference between an asset manager’s multi asset fund and building block funds – with the latter being cheaper – as a result of the cost of the manager’s asset allocation capability. The client will generally pay a bit more for the asset manager’s asset allocation views in a multi asset fund. But as a result of the total cost pressure, DFMs have started moving away from a balanced approach to that of a building block/specialist approach. Essentially moving away from a blend of asset manager asset allocation views, to just one – that of the DFM.

There are generally two scenarios that can play out when a DFM uses building blocks. The building block approach can follow an active or a passive approach. Actively, the client still gets the underlying manager’s active view/picks with each asset class, whereas with the passive approach, the client is 100% exposed to market beta/risk, despite lower fees. In both cases the client only gets one tactical asset allocation view from the DFM, who may not be skilled or experienced enough to execute on this approach. The reality is that cost pressures may lead to situations where the client is bearing the risk of lower quality portfolios.

Conclusion

The role of a DFM is very important for any financial adviser. We have seen tremendous growth of DFMs and for good reason. Surprisingly though, investment experience is something that is often overlooked by advisers when deciding on a DFM partner, especially experience in portfolio management. Its sometimes feels like anyone with a FAIS CAT II licence can now call themselves a DFM. To take the industry to the next level, we need full transparency for DFMs. Allow adviser due diligence and have the necessary investment capability to build robust investment solutions for clients, whether via building blocks, multi-asset or a hybrid approach.