The Financial Markets Authority (FMA) has published its monitoring report on the Discretionary Investment Management Services (DIMS) sector (Report). The Report, based on the FMA’s 2022 survey of DIMS providers to find out how their governance, policies, processes, systems, and controls were used to meet compliance obligations and mitigate investor risk and harm, provides insights and recommendations in five key areas. While the Report’s findings are generally positive, the FMA highlights areas of improvement for DIMS providers.
Who should read this? Why?
All DIMS providers should read the Report and consider the FMA’s comments regarding areas where issues have been identified and reflect on the potential for continuous improvement in existing processes and controls.
What does it cover?
FMA Director of Markets, Investors and Reporting, John Horner, said: “We were generally pleased with what we observed. Where a client allows another person to exercise discretion over investment decisions, it demands a high degree of trust and confidence, both in the people involved, and the processes and controls used.”
However, the Report also identified the following five areas of potential risk, which are likely to be the focus of any subsequent monitoring by the FMA.
1. Conflicts of interest
Good practice was generally identified by DIMS providers in managing conflicts of interest (COI). The Report endorses DIMS providers charging flat management fees that exclude additional brokerage expenses for the purpose of removing turnover incentives.
The Report found that some DIMS providers did not have a COI policy, while others had not reviewed their policies within the last year. The FMA wants to see that providers’ COI are appropriately managed and communicated to investors. It recommends that DIMS providers clearly disclose all of their conflicts (and the implications of these conflicts) and review their COI policies and processes regularly to ensure any changes to organisational structure or arrangements are appropriately managed.
2. Investment management
The Report identified an area of weakness where DIMS providers that manage assets directly often do not limit, monitor, or report portfolio turnover. While some good practices were observed, the FMA also found that a lack of turnover controls meant challenges in managing unnecessary transactions or static portfolios and increases brokerage fees (where applicable).
Stress testing and liquidity controls were also flagged as concerns, where 42% of DIMS providers did not conduct portfolio stress testing, while many had not implemented stress testing policies or procedures at all. This is of particular importance to DIMS portfolios that are managed as a class service, where the FMA has recommended that DIMS providers consider liquidity management measures beyond holding a minimum cash balance.
3. Investment strategy
The Report highlighted the presence of unclear promotional statements and poor disclosure where DIMS providers claim that DIMS funds under management were bespoke or personalised, but were found to be guided by a model asset allocation. Strategic asset allocation (SAA) was also highlighted, where 24% of DIMS providers had not reviewed their SAA policies in the last year. As part of displaying due care, diligence and skill, the FMA recommends that DIMS providers regularly review their investment strategies and SAAs.
4. Investment performance monitoring
Good practice was identified where DIMS providers applied justifiable asset limit frameworks and soft limits for the purpose of notification before an actual break occurs. Asset allocation limits which have a range of 0-100% were highlighted as being unclear, despite such wide discretion being permitted. The FMA highlights that limits of this range should not be used to reduce compliance obligations, where DIMS providers using such a range should exercise particular caution.
Some providers lacked robust controls to manage breaches of investment authority, where a mix of controls were employed by DIMS providers to manage their risks. The FMA recommends trade control policies as an effective tool to monitor and prevent breaches.
The Report also identified that some DIMS providers did not use benchmarks to report portfolio performance against a suitable measure and review the benchmarks applied on a regular basis.
5. Fee disclosure and transparency
The FMA did not find any material issues with the timing of disclosure of fees but did identify that not all fees (or their components) were clearly disclosed to investors. The FMA emphasised that DIMS providers should ensure that all fees and services are disclosed clearly and accurately to ensure that investors are readily able to understand the basis upon which fees are charged.
Our view
The Report is arguably long overdue, with the DIMS industry having been earmarked for closer scrutiny for some time (it was first pencilled for a review under the Rob Everett-led FMA in 2019 but delayed several times including most recently due to COVID-19).
Despite constituting a large proportion of New Zealand’s wealth management sector (according to the Report, the average DIMS portfolio is valued at about $1M) the DIMS industry has also been considered comparatively opaque, with providers not required to publicly report on fees, performance, and other data in the same manner as other licensed entities (for example, managers of managed investment schemes).
This is the first deep dive the FMA has taken into the DIMS industry for details on various factors such as governance, policies, and systems to ensure they align with compliance obligations and to “achieve positive investor outcomes” for investors. While it is encouraging to see that the FMA considers a majority of DIMS providers are conducting their processes and procedures in accordance with their obligations of exercising care, diligence, and skill to investors, the Report has also highlighted room for improvement, which indicates the FMA still sees the potential for risk in this arena.
We expect the spectre of Ross Asset Management and the fallout from that scandal was still fresh in the FMA’s mind as it undertook its survey of the DIMS industry. While DIMS providers should feel reassured that areas of good practice exist, they should not take the Report as an invitation for complacency – particularly as the FMA moves toward its goal of being an “outcomes-based” regulator. The FMA have flagged that they will take supervisory or enforcement action where they identify providers have not met key obligations, and its recent run of regulatory action against other licensed providers suggests that it will not hold back if (or, potentially, when) the opportunity presents itself.
What next?
We encourage all DIMS providers to read the Report and consider its findings. If you have any questions about the Report or DIMS more generally, please get in touch with one of our experts.
This article was co-authored by Andrew Walker, a Solicitor, in our Financial Services team.
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