Commentary: Discretionary Investment Management Services: A viable contender

MinterEllisonRuddWatts

The significant and continuing development of New Zealand’s financial services legislation (generally after the 2008 global financial crisis, although not solely as a consequence of the crisis), has engendered an increased interest by both providers and investors in “discretionary investment management services” (DIMS).

As a consequence of improved regulation and investment flexibility under a DIMS, DIMS is emerging as a viable competitor to the traditional managed investment scheme (MIS) structure.

Robust regime bolsters interest

The introduction of the Financial Markets Conduct Act 2013 (FMCA) regime has closed key regulatory gaps, increasing prudent supervision of providers of DIMS (with class DIMS moving into the FMCA regime and only truly bespoke personalised DIMS continuing under the FAA) and introducing mandatory disclosure and reporting requirements.

Corresponding changes made to the Financial Advisers Act 2008 (FAA) have aligned the obligations of Authorised Financial Advisers (AFAs) that provide personalised DIMS (under the FAA) with those of DIMS licensees (providing class DIMS to retail clients) under the FMCA (see below).

Financial institutions are seeing reinvigorated investor interest in DIMS as a consequence of these changes.

For DIMS providers, DIMS have a number of valuable features:

– FMCA treatment: For those providing class DIMS to wholesale clients only, a DIMS licence under the FMCA is not required. Currently, anyone can provide a personalised or class DIMS to wholesale clients (only) without needing to be an AFA or licensed under the FMCA. Investor protections under the fair dealing provisions of the FMCA will still apply.

In addition, an offer of financial products to a person does not require disclosure under the FMCA, if made through a DIMS licensee who decides whether to acquire the financial products in the course of supplying a DIMS to that person. DIMS licensees can therefore offer unregulated offers to clients as a further investment option.

– Increased agility: DIMS providers can act quickly to adapt to market fluctuations, as a wide investment mandate can allow DIMS providers to make investment decisions without having to obtain the client’s prior consent. In a volatile market, this means certain investments can be disposed of quickly and efficiently. Broader market access: DIMS providers can utilise the benefits of the MIS structure by investing in underlying MIS funds. Investors may also have access to financial products they otherwise may not be able to invest in.

For investors, the FMCA (along with the amended FAA) has provided the following key enhancements:

– Increased scrutiny: Providers of class DIMS to retail clients must be licensed under the FMCA regime. To be issued with a DIMS licence, the FMA must be satisfied the applicant meets the criteria set out in section 396 of the FMCA (which includes whether directors and senior managers are fit and proper persons to hold their respective positions, and whether the applicant is capable of effectively performing the service (having regard to the proposed licence conditions)).

AFAs providing personalised DIMS to retail clients under the FAA are also subject to certain eligibility requirements (including, for example, that they are capable of performing effectively the personalised DIMS (having regard to their authorisation conditions).

– Enhanced duties: Licensed DIMS providers must act in the best interests of the investors using the service, treat all investors equitably and not make use of information acquired through being a DIMS licensee to gain an improper advantage for itself or any other person. Similar obligations apply to AFAs providing a personalised DIMS under the FAA.

– Ongoing reporting: Licensees providing retail DIMS have ongoing reporting requirements, including to disclose to investors certain fees, transactions and portfolio information, and to report to the FMA any material breaches of any investment limits set out in an investment authority. Under the FAA, AFAs providing personalised DIMS to retail clients are also subject to certain reporting requirements.

– Improved disclosure: A provider of a DIMS to retail clients must give clients a disclosure statement that includes information about the provider’s authorisation or licence to provide a DIMS, the fees and/or commissions they will receive, and how the service works. A disclosure statement facilitates the ability of clients to make informed decisions about whether to use the service and/or an adviser.
In addition, providers must have legally enforceable client agreements and written investment authorities. The investment authority must clearly disclose the scope of the service granted by a retail client, including any limits on the nature or type of investments.

– Restrictions on how money is held: A DIMS provider must ensure investor money and investor property are held on trust on behalf of the client by an independent custodian or (if permitted by the provider’s DIMS licence conditions) by an associated person of the provider. Where broking services (which include custodial services) are provided to both retail clients and wholesale clients (excluding “core” wholesale clients), client money and property must be held on trust in a separate trust account, and a broker must not use or apply client money or property except as expressly directed by the client (although note our comments in respect of “broking services” under the section entitled “New financial advisers” regime below).

– Tax implications: As a consequence of the investor holding the underlying financial products (i.e. investments are held on trust on their behalf), rather than an interest in a scheme that invests in those products, the financial position of the DIMS provider has no impact on the investing client. Investors are taxed on any income derived through a DIMS investment at their own marginal tax rates, not the tax rate of the underlying MIS.

– Investment flexibility: Investment parameters under a DIMS can be tailored to suit an investor’s personal requirements and investment methodology. In comparison to investing in a MIS, investors may have more control over how and what they invest in (for example, they may want to focus on, or avoid, a particular industry) without the need to find a fund that fully reflects their requirements.

New financial advisers’ regime

The Financial Services Legislation Amendment Bill (released in February 2017), which is currently before Parliament, will further strengthen the prudential supervision of personalised DIMS providers. The Bill repeals the FAA and moves (but also simplifies) the relevant financial adviser provisions into the FMCA. The proposed changes will not come into effect until April 2019.

For DIMS, the key elements under the Bill are:

– Consolidation of personalised and class DIMS: The Bill consolidates personalised and class DIMS requirements under the FMCA. As such, AFAs wishing to continue to provide personalised DIMS will need to be regulated under the FMCA. To limit disruption however, the Bill enables existing personalised DIMS providers to be automatically granted FMCA licences, subject to conditions.

– Financial advice and DIMS: The definition of a DIMS will continue to include financial advice provided in the ordinary course of, and incidental to, providing a DIMS. As such, advice provided through a DIMS will continue to be treated separately.

DIMS providers will not, therefore, be considered “financial advice providers” for the purpose of the Bill (which necessitates the provision of “regulated financial advice”, which in turn excludes advice given by a licensed DIMS provider or a wholesale DIMS provider). Consequently, DIMS providers will not need to separately consider the new financial adviser provisions when the new regime comes into effect.

– Robo-advice: Automated DIMS are already possible under the FMCA, and therefore advice provided through a DIMS platform as part of providing a DIMS, is already possible. However the Bill allows “financial advice providers” to also provide robo-advice for the first time (by removing the requirement for a natural person to provide advice). Importantly, “financial advice” will include designing an investment plan for a person. As a result, “robo-advisers” in this category may be subject to different obligations than those that apply to DIMS providers.

– Broking services: “Broking services” will become “client money or property services” under the new regime.[18] Similar trust account obligations will apply to persons providing “client money or property services” to retail clients. However, the Bill revokes the Financial Advisers (Custodians of FMCA Financial Products) Regulations 2014, which means custodians providing services to wholesale clients will not, unless new regulations provide otherwise, need to comply with the relevant trust account obligations (although we expect new regulations will ensure wholesale clients are also caught).

Is DIMS right for you?

It is perhaps the flexibility to inform the investment parameters, and subsequently leave the day-to-day management of the portfolio to a portfolio manager, that is most appealing for many investors using a DIMS. Add to this a robust governance framework, and the decision to invest through a DIMS becomes even more attractive.

The FMCA (and consequent amendments to the FAA) has reinvigorated DIMS through an improved regulatory framework that allows clients to instruct investment parameters and risk appetite through an agreed investment authority, maintain a comprehensive investment portfolio and be regularly informed of their investment progression, while having some comfort that their investments are managed in a transparent and tightly regulated manner.

While DIMS may not be suitable for investors who prefer to be actively involved in their investments, a DIMS structure allows DIMS providers and advisers to respond quickly and efficiently to market changes, a key advantage in a volatile market. This can be particularly useful for investors who find it easier to buy positions, for example, than to sell when the time is right (i.e. good portfolio managers will remove emotion from the equation by making the decision for the client). DIMS also provides an opportunity for investors to align the nature or type of investments with their own interests and investment “philosophy”.

While MIS will continue to fulfil the requirement for investors wanting, among other things, to pool their funds with other investors to access a more diverse investment mix, we expect that increasingly, New Zealanders will be looking at DIMS as a strong, alternative investment option.

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