REHOBOTICS – SELF INVESTMENT VS DISCRETIONARY INVESTMENT (Whitepaper)
Asset allocation is commonly accepted as the greater contributor to investment returns. The single most important decision any investor makes up to 90% of returns according to independent research are driven by asset allocation decisions (M.Macdonald 2020). The concept of self-investing or use of a discretionary fund management in generating investment returns would be largely determined by the individual’s ability to create the right asset allocation strategy, detailed history of portfolio compositions that will help provide specific information to aid overall performance or build of a portfolio (G.P.Brinson et al.,1991).
The purpose of this paper is to focus on the two concepts namely
- Self-invest
- Discretionary Fund management
Both have been critically analysed by looking what they are, benefits, drawbacks and other key consideration in long term investing
Self-invest
This are investors that choose to build and manage their own investment portfolios. They self-elect their investment strategies and decide which investments they want to buy, hold, sell at a specific time. Typically, they use discount brokers and online trading platforms to make their trades (unknown). Self-investors are also commonly referred to as Do-it- yourself (DIY) investors or self-directed investors
There are several reasons why an investor may choose to self-invest. Some of which are
- Sufficient knowledge and understanding of specific investment area – Where the investor is a practicing or non-practicing investment professional in that area and possess sufficient knowledge to trade without the aid of an adviser (C.Callus & J.Craig June 2014)
- Investor experience – An experienced built through long term experience of investing, an understanding of risk, access to research tools, access to technology to monitor, review and manage investment on an ongoing basis (C.Callus & J.Craig June 2014)
- Niche or alternative investment – The investment is unregulated, complex or highly illiquid which in most cases financial planners aren’t qualified to provide advice in those areas. (example can be crypto-currencies, futures and options)
- Over the past decade the retail investment industry has embraced self-directed investing. Fuelled by continuous disclosure laws, easier access to financial data and a wide variety of information within easy reach online, investors now have more power to make their own decisions and take control of their investment strategies like never before (A Mclintock 2014)
It is important to understand that whilst an investor might have experienced or gained knowledge of specific investment. The cost of getting it wrong can lead to
- A loss of life savings
- Financial insecurity
- Poor emotional, physical and mental wellbeing
None the less, there are advantages and disadvantages of self-investing
Advantages of self-investing
- Lower charges
The investor typically only pays to cover platform or product provider fee alongside the investment related cost. This would mean savings on initial adviser fee and future related ongoing advice fees (OSC 2020)
- Investment control and decision making
The investor is fully in control of the decision-making process and timing of investment. It isn’t uncommon where investor has experienced a breakdown of trust to opt for self-investing.
- Access to alternative investment option
Investing in more sophisticated instrument such as crypto-currencies and precious metal.
Disadvantages of Self investing
- Time consuming
The investor would need to spend time on researching suitability of brokers or online platforms, use of the platforms, limitation of the research tools, understanding of assumptions that underpin the tools and its output. It is time consuming and the investor may not have the time to do it
- Complex
It can be complex with so many variations in financial instrument, choice of broker, choice of tools and varying outputs. The asset allocation and fund picking process for some investors can be challenging.
- It can be expensive
There may be added charges from rebalancing or fund switching. Where the investor on a frequent basis is making adjustment to the portfolio. This may see the investor pay out more on charges which would have the impact of reducing the gains within the portfolio
- Behavioural bias which may lead to losses (Emotional investing)
Less experienced investors can react irrationally buying when the prices are high and selling when they fall isn’t uncommon amongst self-directed investing. (A.Shuler 2019) quoted the acclaimed father of value investing (Benjamin Graham) who said “Individuals who cannot master their emotions are ill-suited to profit from the investment process.
Discretionary Fund management (DFM)
A discretionary fund manager (DFM) is an individual acting on behalf of an investor with the main responsibility of the investment decision in relation to the client. The decision on buy, sell and hold is outsourced to the DFM who assumes control and charges a fee for the work. They are typically recommended by financial planners who are responsible for due diligence activity before a client recommendation. A full bespoke DFM arrangement provides far greater choice and personalised to the investor.
There are several reasons why an investor and their financial planner could elect a DFM. Here are some of the most common reasons
- Greater access to non-traditional asset – Wider range of investment asset that can be held within the portfolios. This may typically not be available for retail investors or through traditional multi-asset funds or funds of funds. Examples would be gold or silver
- Bespoke portfolios which are tailored to meet the client needs and objectives. Risk is managed according to the set targets with reviews and realignment of portfolios done automatically to manage any portfolio drift
- Access to the fund manager in some cases where questions raised by client can be answered with most investors finding this comforting in a market downturn
- Access to institutionally stock prices which are sometimes cheaper than the retail versions of fund. This discount could mean the portfolio cost is cheaper
- Greater resource to research and analyse stocks
- Managing conflicts of interest – where an individual has access to market sensitive information. Purchases or sales of investment effected in any account over which the investor has no direct or indirect influence or control or in any account of the investor which is managed exclusively on a discretionary basis by a person other than the investor removes conflict of interest (Prudential Financial Inc – no date)
Investing through a DFM doesn’t necessarily guarantee performance. They can prove to be expensive which then reduces returns generated by the portfolio. Where the investor is looking at withdrawing an income. It takes no account of the investors tax position which may trigger an unexpected capital gains tax for asset sat in non-tax efficient vehicles.
Advantages of discretionary fund management
- Portfolio management expertise
The discretionary fund managers have far greater access to research tools and analysis in the portfolio construction process. They have established processes in place to cater for changes should volatility increase and can react quickly
- Benefit from economies of scale
As a result of the buying powers. Discretionary fund managers can negotiate or gain access to institutional share prices which may not be readily available to retail investor. In most cases this will be a variation in share class but at discounted cost.
- Personalised or Bespoke portfolio
The portfolios are tailored to the specific individuals needs or targeted at a specific group based on their attitude to risk and capacity for loss. The key element is that those portfolios are built with the investor’s objectives in mind
- Outsourcing of the investment management process
Less worry for the investor as the DFM assumes responsibility for the day-to-day management of the portfolio. The complexity of the process can be simplified for the benefit of the investor
- Access to a wider range of investment instrument
Greater diversity in asset classes and underlying investment. Access to more niche funds to diversify away from of the market risk. DFM could choose to use commodities or derivatives within the portfolios which may not be available to a retail investor
- Rapid response to market changes
Discretionary fund managers can act quickly where increased volatility that may lead to client detriment is established. This is possible because of the discretionary mandate which enables them to do so.
Disadvantages of discretionary fund management
- Complexity
It can add an additional layer of complexity where a client requires simplicity. The investment strategies and styles could vary from time to time which could lead to confusion as the fund manager reacts to changes in the market (E. Hughes 2015)
- Cost
The expertise of a discretionary fund manager comes at a cost with no guarantee of investment performance. It is an added value service which would increase the overall cost of investing and managing the investment. There may also be additional cost in form of Value added tax (VAT) (V.Pearce 2020)
- Loss of control
There is no control over the timing of the DFM action. Planned rebalances and realignment in some cases may lead to disposal of asset which may generate a capital gains tax liability.
- Difficult comparing performance
It may be difficult qualifying or measuring the performance of the fund manager as in most cases the portfolios are personalised. There may be no suitable benchmark to compare against making performance assessment difficult
Additional factors
- Needs and objectives of the investors
Key consideration should be given to the requirement of the investor and suitability of self-investing or outsourcing should be driven by it. The investor wishes for clarity, simplicity, and lower cost. It may be worth considering alternatives (G.Hepburn 2019)
- The product wrapper
Self- investing or discretionary fund manager were trading is frequent. It is important to understand the implications this may have and taxation that may apply. Pensions and ISA will typically not give rise to taxation when switching within the product wrapper. This is not the case with general investment accounts
- The size of the investment
Discretionary investment management may not be suitable for smaller investment values. The cost associated with it could mean less return for the investors. Most DFM’s will have a minimum investment which means they are not going to be suitable for all investment (M.Webb 2018)
Conclusion
Self-investing and discretionary fund management both have a role to play in meeting the needs and objectives of investors. The early years of savings to accrue wealth can be fulfilled by safely self-investing.
The FCA recently published a warning to younger generation of self-investors following research conducted by Britainthinks. Self-directed investors behave differently, often drawn to high-risk, high-return investment types early (such as investment-based crowdfunding, cryptocurrency, CFDs) and more likely to conduct research using online sources like YouTube and social media for investment knowledge, advice and tips. Their behaviour and attitudes could also underline that these investors are at risk of harm. They have lower knowledge taking high risk and many don’t have that capacity for loss (Dr McNauhton et al.,2021)
The last 10-15 years have seen greater adoption of the use of a discretionary fund manager with financial planners driving uptake by 40-50% and many believe over the next few years the number of investors could increase to 60-70%. (Rathbones, no date)
The expertise and tools at the disposal of a discretionary fund manager may be best suited to the changing needs of investors. Emotional investing poses the greater risk to most self-directed investor which isn’t the case with discretionary fund managers . “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework” (Warren Buffet 1986)
The benefits of discretionary fund management outweighs its shortcomings. It reduces the risk faced by investors when compared to self-investing. There are no guarantees of investment performance. What you get with discretionary fund management is a structured portfolio based on sound principles (not emotions), managed to the agreed risk parameters with timely intervention when required.
Bibliography
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http://www.timothyburger.com/Determinants_Brinson_1991.pdf (Accessed March 2021)
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