A proposed rule from the Securities and Exchange Commission would require an investment advisor that wants to outsource part of its responsibilities to conduct “certain due diligence and monitoring of the service provider.” As is always the case with such rules, there are complexities, including what constitutes a “covered function” that is subject to the rules.
As explored (among other issues) in a previous posting, “We Need Some New Terminology,” the term “investment advisor” is broad, referring to different kinds of organizations. The implications of the proposed rule will vary by the type of firm, its size, the nature of the services provided to clients, and what is to be outsourced. For this posting, the focus is not on asset managers, but rather investment advisory firms.
Reaction to the rule
Given that the additional requirements of the rule will translate into higher expenses, there has been a fair amount of pushback in the industry. An article from Citywire RIA cites some of the objections, including that it is redundant given “an advisor’s existing fiduciary duty to assess service providers;” overly broad definitions and requirements; cybersecurity concerns from disclosure of service providers to the public; and the likelihood of further industry consolidation because of the burden on smaller advisory firms.
An RIABiz posting provides additional comments from industry sources, and references SEC concerns that advisors could “use third parties to address their own expense needs rather than a client’s best interest.”
Scott MacKillop of First Ascent Asset Management, which provides a “turnkey asset management program” (TAMP), penned an opinion piece for Wealth Management, titled “TAMP Users: Get Your House in Order.” He wrote that the SEC wants advisors to:
Have processes and procedures in place to organize and manage due diligence activities;
Perform a thorough due diligence examination before hiring a covered service provider;
Monitor the selection on an ongoing basis to ensure it continues to benefit clients; and
Keep books and records to document and justify the process.
No doubt he’s hoping that his firm will benefit from the increased scrutiny, as indicated in this section (which nonetheless rings true):
If you’ve been sticking with your current TAMP because you’re a member of its “Old Timers Club,” you like its wholesaler, its conferences are really fun or it helps you with your marketing, guess what . . . You’re in trouble. None of those factors benefits your clients.
The drive to outsource
An article in the Economist, “How technology is redrawing the boundaries of the firm,” traces theories of outsourcing to the 1937 work of Ronald Coase, who “argued that firms’ boundaries — what to do and what not to do yourself — are determined by how transaction and information costs differ within firms and between them.” In the investment world there has been a profound shift toward outsourcing as markets have gotten more complex and technology has offered new possibilities.
As perfORM (which does operational due diligence) said in a newsletter regarding asset manager outsourcing, it makes sense “to remove expensive, non-alpha generating functions and outsource them to a scalable third party whose business is to deliver those services expeditiously, cost-effectively, and hassle-free.” An investment advisory firm has an additional dimension to deal with beyond operations and investment management — its information about its clients and their individual needs. All three areas provide risks and opportunities when it comes to outsourcing.
Selection and monitoring
In each, it is easy to take selection and monitoring responsibilities too lightly.
Does the advisory firm have people that are sufficiently knowledgeable about the specifics of the area to make good decisions about the outsourcing providers? Do they have the due diligence skills to go beyond the surface layer of information that has been given to them to identify otherwise unseen risks? Are they driven by price or (in the case of investment-related decisions) by historical performance? Is a risk-based evaluation framework in place — and have the apparent positives and potential negatives been laid out in a way that provides a balanced view? Or are choices made because the provider has been a popular selection by others, so there is the comfort of being with the crowd, even if deep due diligence hasn’t been performed?
Some advisors might be considered experts at all of this (and the required details in the levels below these general questions), but many are not. That stands to be true whether the principles-based fiduciary standard is viewed as the guiding star or the SEC codifies its rules-based solution. Firms need to do some self-assessment regarding these issues in either case.
One example
Opening up private investment vehicles to a broader clientele is a hot topic in the industry these days. Not just the standard “liquid alts” (examined by Larry Siegel in a recent Advisor Perspectives piece) but versions of the private equity, credit, and real estate funds that are so popular with institutions.
Many — probably a large percentage — of advisory firms are ill-prepared for the high-powered marketing effort by the purveyors of those products that is coming their way (or perhaps has already arrived). The historical performance of those institutional funds will dazzle advisors and clients, some of whom have been pushing for a piece of the action. The general partners of the funds are looking to “retail” for the next big flow of assets into their coffers and have a well-honed pitch.
Liquid alts turned out to be a bust overall. Whether illiquid ones will delight or disappoint remains to be seen — will the typical advisory firm be able to properly vet the choices that are presented?
Beyond the rule
While the proposed SEC rule is getting the attention, the general questions behind it are what’s most important. How good are advisory firms at assessing the trade-offs — for their clients, not themselves — of the range of outsourced services that they are employing? How well can they judge the quality of those providers? Does their own circle of competence qualify them to evaluate that of others?
Organizations should want to get better at all of this, whether the rule forces them to do so or not.
Published: March 7, 2023
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