Outside Investment Manager Due Diligence & Disclosure (Templates)

Outside investment managers—such as TAMPs and robo-advisors—are a popular solution for advisors seeking to offer clients expert asset management services without needing to hone that expertise themselves or simply spend the time doing it (as in financial planning-only firms). There are a number of different options when it comes to choosing an outside manager as an advisor and we'll discuss several options. Advisors ultimately choose an outside manager based on their specialized knowledge, research, operational and trading expertise, and reasonableness of fees. Outside managers offer affordable investment management services for smaller accounts and can be a wonderful option for advisors and their clients, just keep in mind that leveraging an outside manager comes along with some regulatory considerations and compliance to-dos.

Investment advisors have a responsibility to perform due diligence on any third party they may recommend to their clients. When an investment advisor recommends an outside manager, they must also disclose the services and fees associated with the outside manager and make appropriate updates to their ADV. I've included due diligence questionnaire templates and examples, as well as sample language for your ADV that I share below. First, let’s define some key terms: 

Key Terms

Outside Manager: A third-party manager, sub-advisor, TAMP, or robo-advisor.

Third-Party Manager: Works on behalf of the client to provide investment management services in tandem with you as the investment advisor. Investment advisors recommend third-party managers based on their specialized knowledge/research, operational and trading expertise, and reasonableness of fees. Ultimately, the client signs an agreement with the investment advisor and also signs an agreement directly with the third-party manager. Both firms charge separate and distinct fees.

Sub-advisor: A separate firm contracted out by the investment advisor to provide specific services related to the management of the investment advisor’s client accounts. Through this arrangement, the investment advisor will recommend the sub-advisor’s investment models to clients, based on each client’s individual needs and objectives. The investment advisor has the discretion to hire or fire the sub-advisor. The client signs an agreement with their investment advisor and the investment advisor signs an agreement directly with the sub-advisor. The sub-advisor does not interact with the client. Traditionally, the sub-advisor’s fees are included in the investment advisor’s fees.

Turnkey Asset Management Program (TAMP): A turnkey asset management program handles the actual process of portfolio management, “from selecting the initial stocks or mutual funds (or these days, ETFs) to then monitoring the portfolio and making investment changes (as necessary) on an ongoing basis.” In turn, this allows the investment advisor more free time to focus on their specific areas of expertise (which may or may not be investment management). (Source: Why TAMPs And Outsourced Investment Management Are The Future For Most Advisors; Kitces.com)

Robo-advisor: A digital platform that provides automated, algorithm-driven services with little to no human supervision. A typical robo-advisor collects information from clients about their financial situation and future goals through an online survey and then uses the data to offer advice and automatically invest client assets. Robo-advisors offer easy account setup, robust goal planning, account services, portfolio management, security features, attentive customer service, comprehensive education, and relatively low fees. Robo-advisors could either qualify as a third-party manager or a sub-advisor, depending on how the contracts are arranged.

Due Diligence Questionnaire 

It is considered best practice for investment advisors who engage an outside manager to maintain documentation around the initial and ongoing due diligence performed to support the decision to recommend the outside manager to clients. The due diligence component of engaging an outside manager is important both initially and on a continual (annual) basis. Some of the information collected during the due diligence process is easily accessible and available to the public. For example, the outside manager’s registration status, disciplinary events, and Form ADV Parts 1 and 2 can be found on the BrokerCheck site. Oftentimes the outside manager’s website can be helpful since it typically contains a listing of staff members, services, pricing, performance, privacy disclosures, and contact information.

It is standard for investment advisors to ask outside managers to complete a questionnaire in order to gain the remaining information collected during the due diligence process. We suggest the outside manager(s) complete a comprehensive questionnaire at the start of the relationship. The ongoing due diligence process will look different depending on which outside manager is used. Some outside managers proactively distribute a due diligence packet on an annual basis that contains updates to answers given on the initial questionnaire. Other outside managers may need to be reminded (on an annual basis) to provide updated information. (Sample questionnaires are linked below.)

• Contact information for the firm and the person completing the questionnaire
• Ownership structure
• Plans to change or expand the business over the next 5 years
• Affiliations
• Material findings from the most recent regulatory audit/exam
• Financial status
• Pending or ongoing litigations or investigations involving the outside manager
• Insurance coverage
• Principal executive officers and Investment Committee members
• Written Supervisory Procedures (WSPs) such as a Compliance Manual, Code of Ethics, Business Continuity Plan, and Data Security Manual
• Portfolio performance
• Investment research, process, and strategies
• Trading practices

Template: Sub-advisor Due Diligence Questionnaire

Template: Outside Manager Annual Due Diligence Questionnaire Template

Template: ​​New Outside Manager Due Diligence Questionnaire

ADV Disclosure Requirements 

When an outside manager is used, there are certain disclosure obligations that must be met. The investment advisor must indicate the use of the outside manager in Form ADV Part 1A, Item 5.G. The outside manager’s services, fees, investment strategies, block trading practices, and discretionary authority are disclosed in Form ADV Part 2A. Sample language for use in Form ADV Part 2A is provided as an attachment at the bottom of this blog post.

Template: Outside Manager Sample ADV Language

As fiduciaries, investment advisors have the responsibility to ensure all recommendations made to clients are in the clients’ best interest. Documenting the due diligence performed on outside managers will demonstrate the investment advisor is ensuring that the third party is a good fit when it comes to managing client portfolios both initially and on an ongoing basis. With robust documentation on file, the investment advisor can sleep well at night knowing they are making decisions in their clients’ best interests and building confidence from an audit preparation standpoint.

About the Author
Shelby Brown is a Compliance Consultant on team XY Compliance Solutions. As a National Regulatory Services (NRS) Investment Adviser Certified Compliance Professional® (IACCP®), she is equipped with the knowledge and tools necessary to implement and manage a successful compliance program at any investment advisory firm—which she loves helping XYPN advisors do. When she's not taking care of compliance business, you'll find Shelby on the golf course, at the beach, or camping in the summer and snowshoeing, crafting, or soaking up a good book by the fire in the winter. She and her husband are always planning their next adventure.