Financial professionals of the future will struggle to get their heads around some of the ways we currently do things. The reliance of financial advisers on discretionary fund management (DFM) is a good example.

Around 37% of UK advice firms use DFMs to manage their clients’ money, and I can understand why they do. Forgive the cynicism, it gives the adviser someone else to blame when returns are disappointing. More importantly, it frees them up to focus on areas where advisers really can add value.

But it’s time for a massive reality check on DFMs. Advisers are hiring them to do something that, for all intents and purposes, can’t be done, namely to beat the market consistently over the long term. In doing so, they are simply adding another layer of expense for their clients, typically around 1%.

Make no mistake, that’s a big deal. As David Pitt-Watson, visiting fellow at Cambridge Judge Business School, recently stated in evidence he gave to the Work and Pensions Select Committee, fees of 1% will reduce the possible size of a pension at retirement by around a quarter.

There are reams of academic evidence to show that beating the market through stock selection is extremely difficult, and doing so through market timing is even harder. Studies of the performance of actively managed funds by the likes of David Blake at Cass Business School have shown that, on a cost- and risk-adjusted basis, only around 1% of funds beat the market over the long term, and that identifying those very few winners in advance is all but impossible.

Why, then, are so many seemingly intelligent advisers willing to sacrifice a quarter of their clients’ eventual returns by paying discretionary fund managers to do something they can’t?

It’s not even a probability that, on average, using a DFM will subtract value; it’s a mathematical fact. Active managers effectively are the market. On aggregate, they will deliver the market return. It is, therefore, a zero-sum game: one active manager has to win at another’s expense. But that’s before costs. After costs, it’s a negative-sum game. Once fees and charges are factored in, the average active investor must — yes, must — underperform the average passive investor, simply because of how much more they’re paying.

Sadly, the only possible explanation for advisers continuing to use DFMs is that they fall for the sales patter and marketing spin. They take the DFM’s word for it that they’ve beaten the market in the past and can do so again in the future.

As anyone who’s studied fund performance in any detail will tell you, there are all sorts of ways of making an investment track record look more impressive than it actually is. The fact is that the performance of DFMs is very rarely benchmarked properly. Nor am I aware of any academic study on the returns they deliver.

In the absence of reliable information, financial advisers and journalists tend to rely on the data provided by DFMs themselves. A recent study led by Tim Jenkinson and Howard Jones from the University of Oxford of the investment consultancy sector found that consultancy firms typically exaggerate their performance buy almost 2% a year. Are we honestly to assume that discretionary fund managers aren’t guilty of adding on a few basis points here and there?

What, then, are the alternative options for advisers who, quite understandably, want to wipe their hands of investment decisions and spend more time with their clients and growing their business instead?

There is no single, optimal way to invest, but all the evidence points to diversifying widely, keeping costs as low as possible and resisting the temptation to tinker.

For those who want to go down the traditional indexing route, Vanguard and AJ Bell offer a wide range of low-cost index stock and bond funds. For those who prefer ETFs, some of the cheapest are currently provided by Lyxor ETF.

For advisers who want to try to beat the market by tilting towards risk factors that have outperformed in the past, Dimensional Fund Advisors provide a very safe pair of hands. There are also solutions, like EBI Portfolios, which combine the two approaches.

With all of the solutions I’ve mentioned there are options for automatic rebalancing. This, too, gives advisers one less thing to think about, and generally delivers better returns than a DFM’s attempts to dip in and out of the market at just the right time.

These are exciting times for advisers and their clients, as whole layers of costs and needless activity are stripped away. Discretionary fund managers certainly won’t be missed.

Follow me

Robin Powell

Robin Powell worked in television journalism for more than 20 years, as a reporter, producer and presenter.

He is the founder of Ember Television, which provides content and social media management for companies worldwide, and which has specialist expertise in the financial services sector.

He also blogs at The Evidence-Based Investor and at Adviser 2.0, is an Ambassador for the Transparency Task Force, which is working with politicians, regulators and the asset management industry to make investment fees more transparent and easier to understand.

Robin is a member of the Chartered Institute of Journalists and was a Visiting Media Fellow at Duke University in North Carolina.

He is based in Birmingham UK and lives in lives in rural Warwickshire with his wife and two children.
Follow me