The nirvana for many financial planners and investors is a seamless system of managing portfolios which takes into account the full spectrum of administration, asset allocation, best interest duty and technical compliance.
The search for the ultimate ‘system’ of efficient portfolio construction and ongoing management has led to some interesting innovations. Here, Select Asset Management’s Alex Wise looks at the evolution of the underlying product structure with an eye to the top-line investor benefit.
Efficiencies in portfolio management have long been a goal of savvy investors and their financial adviser. But today we are shackled with the onerous task of reporting compliance, Dreaded paperwork. The process of completing a Statement of Advice (SoA) for material changes or a Record of Advice (RoA) for minor changes each time a change in investment is required is a tedious and intensive process for all concerned. Moreover, client investments may be put at risk when markets begin to gyrate. Advisers may not produce timely, written advice to be acted upon quickly enough in order to protect clients. Similarly, clients are often unable to take advantage of short-term mispricing opportunities.
Solution? Two investment structure approaches have evolved to provide a more responsive investment solution for clients. They are, firstly, the use of a multi-asset unit trust as a core portfolio tool and, secondly, the use of managed discretionary accounts (MDAs), while an increasing number of advisers are considering a hybrid solution as the best of both worlds.
Managed Discretionary Accounts
MDAs are provided by a financial planning, fund management or brokerage house – each working as an MDA operator (“Operator”). Typically an Operator manages a portfolio of equities for a client on an individual or model basis, although solutions exist encompassing other non-equity assets. A client gives the Operator discretionary authority to make and implement investment decisions on his or her behalf. Importantly, client approval is not required for each investment decision. This also means that reporting requirements to clients can be simplified and the Financial Planner is not required to to engage the client in advance each time an investment decision is made.
Certain MDAs can be tailored specifically to the requirements of each individual client. Bespoke MDAs, called individually managed accounts (IMA), require higher minimum investment amounts in order to be practical. More commonly the MDA operator will apply the same investment decisions to multiple client accounts according to a model portfolio i.e. a separately managed account (SMA). Importantly, from a legal perspective, the client holds a direct legal or beneficial interest in the underlying assets within the MDA. This is distinct from managed investment schemes where the underlying assets are held by a unit trust, and the client has a direct interest (a unit) in that trust.
For clients with larger balances, the MDA offers increased control, however, the expense associated with operating an MDA have made it impractical and commercially challenging for small to mid-size clients to get the benefits of a tailored MDA. Clients with larger sums to invest are able to take more or less risk depending on their appetite or investment preferences – for example, financial securities could be excluded from a bespoke MDA account; perhaps not a bad thing given current valuations!
Some MDAs can offer portfolio protection via derivatives or options strategies. However, these protections are not available to all clients as they depend on the Operator’s regulatory status and whether they can transact derivatives on behalf of their clients. Many fund managers and financial planners acting as MDA operators don’t have the necessary licence to use derivatives or options. This can leave clients exposed without portfolio protection in times of market volatility. However, for those clients that benefit from an Operator with derivatives experience, market protection strategies can insulate portfolio returns from severe downturns in market values. All with the attendant risks, of course!
Importantly, the tax impacts of investment decisions remain specific to each client. This means that the Operator ensures that the client’s tax consequences are insulated against the impact of other investors. Unit trusts offer a similar outcome for all clients.
It is worth noting that many Operators have a lack of experience outside of equity securities. This can leave clients facing low or non existent access to bond and other markets (as well as derivatives outlined above).
One further criticism of MDAs is that they usually do not allow access to global investment markets and outcomes. Whilst many investors are satisfied having 100% of their investment outcome linked to the ASX, many others are now seeking exposure to fixed income or Term Deposits. Global equity markets – including established markets like the US – or more exotic emerging market locations may be in favour.
Additionally, incentives for MDA operators have also been called into question by some observers. The use of brokerage commission as a remuneration tool has been linked with an incentive to churn the portfolio, meaning that clients will participate in more trades to generate higher commission for the Operator or their affiliate.
Detractors of the MDA model also point to the lack of accessible performance data. Unlike unit trusts which have audited track records, the performance of MDA operators on a risk-adjusted basis is less clear.
The universe of fund managers operating MDAs is relatively small except in the case of Australian Equity managers.
Many skilled fund managers generating market outperformance or alpha can be difficult or impossible to access via an MDA, particularly the universe of high quality offshore managers. As such, MDAs can also offer access into unit trusts to access these high quality managers. However, even access to these managers via a unit trust can be fraught with difficulty as many highly skilled managers have high entry levels precluding MDAs from rebalancing into these managers.
For the Financial Planning business considering operating an MDA the costs can be high. Australia’s regulatory authority, ASIC, is considering implementing higher minimum capital requirements for MDA operators which may deter many prospective Operators from offering MDA solutions. Many Operators also suffer from internal costs associated with reporting. Clients who require customised portfolio reporting creates a business drag on the desired scale efficiencies in reporting, including performance and portfolio reporting.
Multi-Asset Unit Trust
Many financial planners are also utilising or considering the use of a multi-asset unit trust to act as a core portfolio. Like an MDA, the discretion to make investments is vested with an investment manager which can be the financial planning group or a third party manager. This obviates the need to make ROAs and SOAs every time a change in investment is required.
The unit trust would then make investments into third party fund managers or direct assets that can be based in Australia or offshore. Groups that utilise the unit trust solution enjoy the ability to access any investment fund anywhere in the world.
Whilst this approach requires research, many unit trust sponsors will utilise an asset consultant or third party manager to implement research on these funds.
Endowment ‘likes’
Access to the global talent pool is important for investors who seek to diversify their returns from solely Australian equities or fixed income. Many sophisticated investors are now looking for “endowment like” portfolios that deliver long term returns. These investors view the ASX as being increasingly volatile and the access to unique investment strategies offshore can reduce overall portfolio volatility over time.
Access to market protection is also a key selling point of a unit trust with a unit trust operator being able to hedge foreign exchange, interest rate and market exposure. These traits are important for those seeking endowment like characteristics.
Responsible entities of unit trusts are subject to rigorous supervision from the ASIC. Supervision visits and high regulatory capital requirements mean that responsible entities operating a unit trust are subject to higher regulatory standards than MDA operators.
Unit trust structures do come at a price however, and the fixed costs of operating a unit trust can preclude access from smaller groups with small amounts of funds under management. Whilst providers such as Custodians and Auditors offer protection to investors, they charge additional costs which are typically recharged to unit holders. Moreover, any third party responsible entities or asset consultants will need to receive fees for their services.
Additionally, ownership of the underlying assets is co-mingled and clients hold units in a trust rather than the underlying investments. As such investors are subject to the redemption rules of the unit trust rather than having the ability to sell investments directly into the market.
Summary
Whilst MDAs and Unit Trusts deliver significant efficiencies to clients and advisers, both also bring pros and cons which should be understood prior to embarking on either strategy. The ability to access a global investment talent pool through a unit trust is tempered by the lack of direct ownership of investments and additional costs.
The MDA often lacks ability to enact portfolio protection from violent swings in foreign exchange rate, interest rate or market movements. Additionally, the limited pool for accessing investment ideas through an MDA can be off-putting for some clients. Many financial planning groups are proposing solutions that include a unit trust for a core portfolio but on an MDA platform for satellite investments so that benefits of both can be realised.
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