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Advisers warned on portfolios as Mifid tests loom

Jack Gilbert explores whether adviser-built model portfolios can stand up to the triple test of Mifid II regulations, increased volatility and meeting client expectations

Advisers warned on portfolios as Mifid tests loom

Volatile markets combined with Mifid II regulation are about to create a tough test for financial advisers who have built their own model portfolios.

At the end of last year, financial markets entered what many commentators referred to as ‘choppy waters’. The FTSE 100, for example, fell 12.7% over the last three months of the year. Following this dip in market performance, New Model Adviser® heard a number of platforms had to send out 10% portfolio drop notifications (a Mifid II requirement) to IFAs’ clients over the Christmas period.

Although the market has recovered at the start of 2019, most analysts expect volatility and downward trends to continue through this year.

This could pose a problem for those running advisory portfolios, according to Mark Polson (pictured below), principal of The Lang Cat consultancy. He pointed out many such portfolios have only experienced the ‘benign’ bull markets of the past nine years, meaning their strategies have not yet been tested fully. But further market turbulence could expose how diversification has turned some portfolios into ‘very expensive trackers’.

Added to this are new Mifid II performance and fee disclosure requirements, which will show clients in detail how much they have paid and exactly how well their funds have performed. 

Closet trackers?

Despite the often repeated view that more advisers are outsourcing to discretionary fund managers (DFMs), many advisers still use portfolios they have created themselves. In 2018, a New Model Adviser® survey of 205 advisers found 28% of clients were in advisers’ in-house model portfolios.

Digging into what is inside these models, the research found 56% of them are in third-party active funds and 30% in passives (see pie chart, below). The majority (86%) of advisers are using risk-rated models. The most-used fund houses are Invesco Perpetual, Schroders and M&G.

According to Polson, under the bonnet of many advisory models are highly diversified portfolios with 30 or 40 funds, with each one of those funds holding dozens of company stocks. Polson said the worst case scenario in the event of a market crash was that these portfolios will just follow the market down.

‘The worst situation is if the global index drops 15%, these portfolios follow it. Then what you have done is effectively buy something that is a very, very expensive tracker because it is so diversified,’ he said.

‘If you look inside a lot of the portfolios, the level of diversification is amazing; 30 or 40 highly diversified funds. By the time you have bought 20 funds in a portfolio, each of which has 40 or 50 stocks, you have 800 different instruments so you have probably roughly bought the index.

‘These have been built with the best intentions but maybe if we started again we would have done things differently.’

Lawrence Cook, director of marketing and business development at DFM Thesis Asset Management, said IFAs could face issues when running their own portfolios for clients in decumulation when markets fall.

He gave the example of if a portfolio in accumulation falls by 10%, you only need 11% growth for it to recover. But if the portfolio falls by 10% and the client takes 5% withdrawals, the adviser would need 18% portfolio growth to get it back where it was.

‘There is an unintentional blindness going on in portfolios,’ he said. ‘If they are in a sensibly diversified portfolio and they are accumulating, [IFAs] should be OK. But if a client is taking income, they have a problem.’

The scrutiny on these portfolios is likely to increase when a new Mifid II requirement comes into force this quarter. Ex-post disclosure will require platforms to send out an annual breakdown of costs and performance in pounds and pence for the first time.

Nathan Fryer (pictured below), director of outsourced paraplanning firm Plan Works, said this new disclosure requirement will put pressure on IFAs who have talked up their own investment expertise – particularly with some of the sizable portfolio drops coming through.

‘We have seen positive markets and everyone seems to think they are a fund manager. In reality, no one really knows where the market is going,’ he said. ‘If you are sending your client an annual suitability review that says your portfolio has dropped 5%, and by the way I am taking £5,000, in some instances that will be difficult.

‘So I do think portfolios will be tested and it will be those advisers who have sold their services based on investment performance who will face the biggest test from their clients.’

Testing diversification

Across the 35,000 advisers in the market, there is a huge disparity in how well IFAs have been developing their own portfolios – but taking different approaches and with varying levels of sophistication.

Richard Haines, investment director of Newport-based Gould Financial Planning, puts together client portfolios with around £500,000 with 21 funds  and 15% in cash (see breakdown and performance below).

He said these portfolios are built with the idea of managing risk in all market environments. This means the firm has lost some of the upside in recent years to protect against a rise in volatility.

‘It just so happens that with volatility forecast, we expect our strategy to perform better under these conditions. We have sacrificed some upside over the past few years in a bid to reduce volatility risk for clients,’ he said.

Haines said the firm’s six risk-rated portfolios are stress-tested against various situations, such as a tech crash, by asset manager Natixis each year. The ‘general rule of thumb has been we have delivered less volatility and have slightly outperformed the market average’.

However this testing has also addressed the portfolio’s diversification. Haines said the firm was previously using a Vanguard All-Share tracker and a Vanguard income tracker fund. But Natixis questioned whether both funds were needed as the investments they hold are so correlated.

‘Natixis does look at whether you have too many funds,’ he said. ‘It is a conversation we have had internally in the past because I think there is a danger you get to a point where you start to diversify return away as well as some of the risk.’

Jeffrey Deans (pictured below), managing director of Glasgow-based Save & Invest, stress-tests portfolios with clients over different volatility situations to ensure they can cope with ups and downs.


For the firm’s low-to-moderate volatility portfolio, there are 13 mainly active funds (see holdings and performance below).

Deans said the firm’s clients are largely in or very close to retirement, meaning the emphasis is on protecting the wealth they have built up rather than targeting very high returns.

Deans said it is going to be a ‘big challenge’ for advisers running their own models in this ‘lower return world’. However, he said there have been some ‘traumatic moments’ in markets over the past 10 years and IFAs should resist the temptation to tinker too much.

‘There will be volatility and those who manage portfolios have to stick to their beliefs and not make radical changes,’ he said. ‘As long as clients have reasonable expectations and understand how portfolios can fall, they will grin and bear it.’

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