Why financial advisors should be shareholders in an asset management company

By: Alex Funk, CEO, Cinnabar Investment Management

Fully aligning the interests of financial advisors and their clients has the potential to change the way investment works… to the benefit of both parties.

Financial advisors exist to provide clients with advice on how to structure their financial affairs to best effect. However, because of the way they are rewarded, they have limited direct incentive to ensure peak performance of their client’s portfolio – they are merely incentivised to keep the investments on the books.

At present, financial advisors advise on tax planning, retirement planning and estate planning. This is the major part of the value proposition of the smaller, independent firms, and it is built on understanding the client’s long-term goals. Historically, advisors have also helped clients select the right portfolio of investment funds to meet their financial goals. They are paid a fee for their services, usually calculated on a percentage of the assets under advice.

This fee is not linked to the performance of the client’s portfolio.

One might say that the financial advisor’s role as sketched above falls into two broad areas: planning and strategizing on the one hand, and investment selection on the other.

Over time, it has become apparent that independent financial advisors are finding it increasingly difficult to undertake the asset management required to assist clients achieve their investment goals. The truth of it is that there is now such a plethora of investments available both here and globally that a small independent firm simply does not have the infrastructure and time to perform the continuous due diligence that is required to understand each fund’s investment philosophy, the calibre of its team and its performance compared to the benchmark – as they are required to do in the forthcoming regulation, retail distribution review (RDR).

Some solutions…

In response to this problem, discretionary fund managers came to the market, offering to provide the in-depth financial analysis to enable financial advisors to comply with regulations and, in the end, deliver the best results for their clients. However, it is extremely difficult for financial advisors to establish what the true performance of these discretionary fund managers actually is. Because they are not properly regulated, their model portfolio performance is not published and thus there is a lack of transparency relating to their performance.

Another issue is that these model portfolios are inefficient with regards to the price of the underlying investments. Investors have no option to negotiate better rates – and rates have a cumulative effect on the performance of any investment.

Furthermore, model portfolios are not unitised and thus create a capital gain tax liability whenever the portfolio is rebalanced or changed.

To avoid some of these roadblocks, it is advisable to use a discretionary fund manager that offers a unitised model portfolio, or Fund of Funds. This structure will avoid the capital gains tax issue noted above, and also allows for some negotiation on the costs associated with the underlying funds.

In addition, Fund of Funds price and performance is published and widely available, thus ensuring performance transparency. This makes it easy to identify poor performance.

..but more needed

For these very good reasons, the UK market is moving towards using unitised model portfolios, and our market generally follows suit.

Moving to the Fund of Funds of model is not the whole solution, however, because the interests of the financial advisor and the client are still not fully aligned. As noted above, the advisor’s fees are wholly unrelated to the performance of the client’s portfolio. Of course, a responsible advisor with a long-term outlook would always want to do the best for his or her client but, in the final analysis, his or her fee is not tied to how well the investment performs.

There is a relatively easy way to create a direct link between the performance of the client’s portfolio and the financial advisor’s reward: allow the financial advisor to invest in, and gain part-ownership of, the discretionary fund manager and ultimately the asset manager that owns the unitised model portfolio or Fund of Funds. At a stroke, the financial advisor suddenly has skin in the game because his or her reward (his or her dividend from the shares in the company) is directly linked to the performance of the client’s portfolio.

In addition, as shareholders in the asset management firm, financial advisors are much closer to the investment team and its thinking, they will be privy to the details of how the portfolio is constructed. They can relay this detailed information to their clients and, as needed, feed client input back into the whole process.

At the same time, I should probably stress that none of this compromises the independence of the advice and research produced by the asset management firm. Its sole focus is on assessing the strategies, teams and performance of the funds it deals with – it is the financial advisor who then makes use of this skilled resource to assist him to invest his clients’ money.

In short, this approach means that financial advisors are better able, and better incentivised, to ensure their clients’ outcomes are bettered – good news for both parties.