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Fiduciary rule prompts more firms to outsource portfolio design

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With only so many hours in the work day, would you rather spend time on crafting winning portfolios or building relationships with clients?

Many advisors might prefer to do both, but they increasingly need to outsource portfolio construction in favor of spending more time working on a client's holistic financial picture, according to Tom O'Shea, associate director of Boston-based consulting firm Cerulli Associates.

The Department of Labor's fiduciary rule is a "catalyst for long secular trends" away from the commission-based model of picking stocks and funds for clients, says O'Shea, who is the lead author of a new report looking at how firms have been adapting their approach to portfolio construction.

Home offices, Cerulli finds, are looking to centrally manage their advisors' portfolios or outsource them to a third party as an insulating force to protect their firms from legal and regulatory risks.

O'Shea notes the rise of so-called reps as portfolio managers, who design custom portfolios and often work in a fee-based compensation model. In turn, firms have heightened their supervisory controls. If they observe that individual advisors' custom portfolios are lagging in performance behind a centralized model developed by the home office or a third party, they begin to fear liability risks.

"The thing is that this type of program ― rep as portfolio manager ― has brought a lot more oversight to that kind of activity," O'Shea says.

"So while the firm may not have been aware of that, as they extend their supervision over this type of program, they're becoming much more aware of it," he adds. "Once they know it, that puts them at risk."

And, Cerulli has observed, those custom portfolios tend to underperform, in part because the home office models are more insulated from the behavioral finance aspect of investing, where jittery clients can lead to jittery advisors.

"We see that advisors are very quick to get out of a down market, but very slow to get back into the market ― a rising market," O'Shea says. "The flows in and out of a home office market are pretty consistent and aren't swayed by market movement."

But the regulatory concerns are only part of the picture. O'Shea also sees the rise of digital advice tools transforming an advisor's practice, in effect commoditizing portfolio construction while leaving advisors free to work with clients on other planning issues.

"It's going to force advisors to really have those holistic financial planning conversations," he says.

Independent broker-dealers have been more eager to outsource portfolio construction than independent RIAs, but over time, O'Shea expects that most smaller firms will move in that direction.

In the RIA space, he notes a "barbell" effect, where large shops ― say, those with upward of $500 million in AUM ― can afford to have one or more designated staffers whose chief responsibilities involve studying the markets and selecting stocks and funds. Some even have an in-house investment committee led by a CIO.

"We do see that those types of practices perform fairly well, and we anticipate that they'll continue to have discretion," O'Shea says.

"But if you're a one- or two-person practice and you think your value-add is asset allocation and securities selection, we really think in the future you're going to really need to rethink your value to clients," he adds. "The best thing you can do is build relationships and help them with financial goals."

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