Obtaining investment advice

 In Finance & Investments

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“The internet, and the Retail Distribution Review, put downward pressure on charges for both active and passive funds. The fees you pay are as important to the outcome as the investment choices you make.” Professor John Kay, Financial Times, 9th January 2016.

Obtaining Investment advice

Forty years ago obtaining investment advice for trustees or individual clients was straight forward: you instructed a stockbroker to advise. Such advice was nearly always followed, resulting in a portfolio that had a focus on individual blue chip equities and corporate debt: there was an implicit understanding that by instructing a stockbroker the risk of holding equity investment was accepted. Periodically, usually every six months, the stockbroker would review the performance of the investment choices that had been implemented. The stockbroker was paid by the commission generated on sales and purchases.

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What has changed?

There are four major structural changes that have occurred –

  • The business model of investment advisers is now focused on long term client relationships and, with it, the payment of an ongoing fee. There are often additional charges for the client to pay.
  • There is much greater regulation of those authorised to give advice and about how and what advice is given.
  • As well as the creation of the Financial Conduct Authority (FCA) to supervise those in the investment business, there is also the Financial Ombudsman Service (FOS) to adjudicate on complaints from investors.
  • In the main, financial assets have dematerialised. Share certificates have been replaced by an entry on a “platform.”

The result is a more complex world where legal advisers need to be aware of the risks faced by trustees and individuals when they seek investment advice. One of the biggest risks is not recognising what are high fees and not appreciating the debilitating effect on capital assets of such fees. If the cumulative result of fees is to take all the natural income from a portfolio so that the “income” taken by a beneficiary is effectively a payment from capital, then when a market downturn occurs the capital loss will be greater. In any event, the gradual erosion of the capital base will have a detrimental cumulative effect.

Some detail

It takes significant analytical skill to find an individual quality company at reasonable value. Some advisers and fund managers will make mistakes: a year or so ago Warren Buffett purchased – and then sold – a large holding in Tesco:  in 2006 a stockbroker recommended and purchased shares for my late mother in RBS. To spread risk and to minimise a mistake, the approach of many advisers over the last few years has been to purchase collective funds i.e. to focus on investment houses and fund managers that have the analytical skill to avoid the dross. Funds that track an index have become more common. Each can have a place in a portfolio.

For most investors there are two cost centres: those costs taken by these collective funds and then the costs paid to the adviser who chooses the funds and deals with changes. There has been a lot of focus recently on the costs in funds. Neil Woodford, a popular and effective fund manager, was the subject of a report in the FT on 9th April 2016. The article began –

“Neil Woodford’s decision to reveal the “hidden costs” of his popular equity fund has been applauded by investor groups, who are urging other fund management houses to follow the star manager’s lead.”

On the 9th March 2016 the FT had reported –

“David Pitt-Watson of London Business School has researched the long term impact of fund charges on overall investment performance. He estimates that real average costs for retail investment funds could typically be around 2.21 per cent per year. FT calculations show that compounded over 40 years this level of charges could reduce the value of funds saved for retirement by more than 40 per cent.”

That level of cost is significant. Still to be deducted are the adviser’s costs for implementing the investment strategy.

A conflict

As with the sale and purchase of many assets, there is a wholesale and retail cost to dealing with individual company shares. At a wholesale level the institution must obtain “best execution.” This regulatory obligation is observed if the purchase or sale is at (or better than) the strip price. The strip price is the price shown on the computer screen showing the best price available after comparing what is on offer from the market makers (or wholesale dealers).

If the deal is by computer that strip price is the price at which the deal is struck. However if the deal is large enough with a little more effort (i.e. some telephone calls) it is usually possible to get within, i.e. better, that strip price.

More importantly for the client, at what commission rate is the deal charged to the client? The investment adviser should be able to bulk up its deals, that is put together the sale or purchase order of several or many clients. That should make it possible to deal at a commission rate of 0.1-0.2% and beat the strip price too. When shares are sold or purchased on an execution only basis it is this difference between the wholesale rate and the rate charged to the investor that supplies the investment adviser with its profit margin – just as it did forty years ago.

What has changed is that with some advisers the difference between a wholesale charge, which the investment adviser pays, and a retail charge, which the investor pays, still exists AND an annual fee calculated as a percentage of the funds under management (FUM) is also charged. With an emphasis on discretionary fund management the investment adviser has control over when investment changes are made and each time that occurs a gross profit can be generated for that investment adviser.

Research payments

If this difference between wholesale and retail commission charges is raised a retort can be that the additional charge is made to cover the costs of the adviser executing the deal. But is there not the expectation that this should be covered by the annual percentage charge on FUM?

Writing in the Financial Times on 6th February 2016, Daniel Godfrey, a former chief executive of the Investment Association, advocates that “funds must stop charging for research.” Mr Godfrey was focusing on the dealing commission paid to brokers when shares are bought or sold by an investment manager i.e. the wholesale charge. The figures quoted as to what is the FCA’s estimate is startling. The article states –

“The FCA estimated that investment managers spent £3bn in clients’ money on dealing commission in 2012 and that those same investment managers got £1.5bn of that money kicked back to them in the form of “investment research.”

The article goes on to say-

“One shining light is Baillie Gifford, which is the first big UK institution to announce a move to execution only rates for all their brokers from this year – meaning they are now taking the cost of corporate access and research on to their own profit and loss, not making clients pay for it as an added cost. Others will surely follow.”

This article elicited a reader’s letter published the following week which included the comments –

“It is a system that makes most of its insiders a lot of money for very little value add. Most broker research goes straight in the bin; too many managers can’t even track the benchmark. One chief investment officer said to me once “the trouble with our industry is that it is just too profitable.” That profit is coming from savers.”

Advisory or discretionary fund management?

There is usually a choice between the two forms of investment management. Forty years ago a solicitor nearly always had an informal advisory portfolio management agreement in place with the client’s stockbroker. The stockbroker wrote with proposed changes, for example to rebase and use the annual CGT allowance, and that advice was usually accepted and implemented.

The position is now different. Most wealth managers will offer both services but if advisory is chosen there is still an annual percentage fee based on FUM. There is more emphasis on having a discretionary service – reasons often given in favour are that the price of the share could have moved against the investor by the time the decision to buy or sell is taken, or that an advisory service removes the flexibility of the investment adviser to react quickly in volatile market conditions. There can be a reduction on offer of the annual percentage fee if there is a discretionary service, but very unlikely if an advisory service.

The other factor to consider is how much dealing will take place and at what cost. It is probably not sufficient to just know that the annual charge will be 1.25% of FUM at a certain date and that changes in investment will be charged at a dealing rate of 1%. If the wholesale dealing rate the investment adviser pays is 0.1% and the investor is charged 1% how does the investment adviser manage this conflict of interest?

Independent or restricted advice?

With the Retail Distribution Review (RDR) came a more stringent test to qualify under FCA rules as an independent adviser. Some wealth managers decided to register as restricted advisers. That has commercial advantages, one of which has been highlighted in an article published in the February 2016 edition of the STEP Journal.

In the article entitled “A whole new ball game” Patrick Connolly a certified financial planner writes –

“Our research shows that 13 of the largest 16 financial advice firms in the UK provide restricted financial advice. Of this list 12 sell their own products, platforms or investment funds. This is a key reason for some firms deciding to be restricted. They can earn bigger margins by selling their own products than by selling third party products. However, people need to be aware that some “own brand” financial products can be expensive and may not offer the best value compared with other products on the market.”

Prior to the RDR solicitors instructed independent financial advisers. In 2012 the SRA changed the rules, after a consultation document, to permit the instruction of a restricted adviser. Chapter 6 of the SRA Code of Conduct 2011 sets out the four outcomes to be achieved, two of which are what are in the best interests of the client and to ensure the client is in a position to make an informed decision. At the time of this rule change the Law Society warned solicitors of the dangers of not instructing independent financial advisers to advise clients. Those dangers are still present.

Another development over the last few years has been for some independent financial advisers to instruct other (often restricted) advisers to act as a discretionary fund manager (DFM) of a client’s money. It is not unusual for that DFM to make a payment, usually ½% pa of the value of the FUM, to the introducing adviser. With some DFMs, this payment cannot be “saved” by instructing the DFM directly. In the key feature document sent to the client this annual ½% fee often will be detailed as an adviser payment charge to cover the cost of ongoing reviews by and financial advice to the client from the introducing financial adviser.

Investment risk

This is an area of considerable focus both by the regulator and advisers. An interesting decision by the FOS was made on 2nd November 2015 (DRN0536372). It involved David Jones Financial Planning Limited (DJFP) referring a client to a DFM. The complainant, Mr G, had previously had 100% equity exposure. The Ombudsman found that 90% of capital was invested in assets that exposed the capital to material risk, with at least 20% at very high (speculative) risk. With the stock market turbulence in January 2008 Mr G asked several times about “exit strategies.” The Ombudsman found Mr G a “balanced” or “moderate” investor.

DJFP made several arguments in its defence, one of which was that the speculative element was about 2% of Mr G’s overall wealth and that the advice to remain invested, which Mr G “understood” proved successful as the portfolio increased by 45% between March 2009 and April 2011.

The decision should be read in full to give proper flavour of what occurred. The Ombudsman awarded Mr G £250 for distress and also directed that DJFP should compare performance of the portfolio with the FTSE WMA stock market income total return index and pay any difference in comparative values. The report does not indicate whether any loss would arise as a result of this calculation.

The lesson of this case is to ensure that risk levels of trust and client’s investments are properly determined and communicated and that returns are monitored.

Instructing financial advisers

The FCA’s Financial Advise Market Review consultation closed in December 2015. Preliminary findings could be published this Spring. This is likely to bring more change. Whether those changes will reduce fees further is unknown.

In the meantime lawyers seeking investment advice for clients should ask probing questions to determine the extent of all direct and indirect costs to be paid by potential investors, how conflicts of interest are managed and how performance of investments is monitored. The results of these determinations need to be documented and reviewed. Investment can be a risky business and some of that risk can be underwritten inadvertently by instructing lawyers.


This article first appeared in the April 2016 issue of Trusts & Estates Law & Tax Journal, published by Legalease and is replicated here by kind permission

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