The Financial Services Authority’s recent guidance on 'Assessing Suitability: replacement business and centralised investment propositions' generated considerable debate. Some commentators suggest it implies that model portfolios are dead; others consider it merely restates basic principles.

Centralised investment propositions (CIPs) take various forms, including distributor-influenced funds, discretionary investment management (in-house or outsourced) and ‘portfolio advice services’, a term the FSA uses to encompass model portfolios and the consultation that preceded it after propositions and before generated.

• The FSA acknowledges that CIPs can offer benefits:
  clients get structured, better-researched investments;
• firms manage investment selection risks more efficiently;
• advice becomes more consistent.

However, the FSA states very clear concerns:

• shoe-horning – a one-size-fits-all solution, not suiting a client’s needs and objectives;
• churning – switching clients into a CIP, even if this is not in their best interests;
• costs – higher costs may outweigh any benefits.

Even so, the FSA accepts that CIPs can be adopted if implemented properly. Examples of good practice include:

• researching target clients’ needs and objectives before deciding to offer CIPs;
• producing varying CIP solutions for different client segments; for example:
• a preferred fund panel for transactional clients;
• low-cost managed funds for clients with modest assets;
• model portfolios for clients with more assets and investment experience, where the additional costs are appropriate;
• discretionary fund management for clients needing bespoke investment management solutions.

Particular issues arise if using a third party’s CIP solution. Due diligence is essential to ensure that the CIP meets clients’ needs and objectives. Further, if investment selection is outsourced to a discretionary fund manager (DFM), the FSA suggests that both the introducing firm and the DFM must ensure that personal recommendations or decisions to trade are suitable.

This is a controversial section of the FSA’s paper, although it acknowledges that the obligations on each party will depend on the exact services they are providing. The FSA mentions three models:

1. the firm arranges for the client to have a direct contractual relationship with the DFM;
2. the firm outsources actual management to a third party, but retains responsibility – in which case the adviser firm will need to have the necessary Part IV permission to carry out discretionary investment management; or
3. the fim contracts, as agent for the client, with the DFM treating the firm as its client.

The FSA’s analysis does not address the involvement of platforms, or some of the difficulties involved in assessing suitability, either for the adviser or the DFM. Care with the paperwork will need to be taken here; and there are some tricky VAT issues to navigate as well.

If model portfolios are adopted, the guidance consultation suggests these steps are important:

• check that the portfolios accurately reflect the outputs from risk profiling, and keep this under regular review;
• check the suitability of any proposed solution for each client;
• explain the risks attached to the underlying investments;
• if a model is not suitable, recommend an alternative (or make no recommendation);
• ensure that advisers understand the model – its costs, risks and drawbacks as well as its benefits;
• identify and manage conflicts of interest;
• carry out rigorous file checking;
• produce appropriate management information to monitor risks.

Model portfolios must not, therefore, be regarded as the sole solution; they are, at most, one tool in the kit that can be used. And, given the FSA’s concerns, they need to be handled with care. In particular, due diligence, reviews and good records are essential to avoid falling foul of the FSA and its successors.

By Nick Rutter,
Partner, Financial Services, Maclay Murray & Spens LLP