What Due Diligence Should an IFA Complete Before Adding a Fund to a Client Portfolio?

Selecting a fund is not just an investment decision. For an independent financial adviser, it is also a governance decision, a client suitability decision and, ultimately, a professional judgement about whether the fund is likely to do what it says it will do for the type of client it is being recommended to. Whilst not the most exciting of investing topics, it is still very important.

Those with experience will know, a fund can look attractive on a factsheet and still be a poor fit for a client portfolio. Indeed, it may have strong short-term performance but unclear sources of return. It may be run by a respected manager but rely too heavily on one individual. It may be cheap but structurally flawed. It may be theoretically suitable for the target market but too small, too concentrated, too illiquid or too dependent on future asset flows. Proper fund due diligence is therefore not about finding the fund with the highest recent return. It is about understanding what the fund is, how it works, who is responsible for it, what could go wrong, and whether it remains appropriate for the clients for whom it is intended.

The FCA has made this point repeatedly. In TR16/1, the FCA set out findings from its thematic review of the research and due diligence processes advisory firms use when recommending products and services to retail clients. Its guidance on replacement business and centralised investment propositions also made clear that firms need to be able to demonstrate why a recommended solution is suitable, rather than simply placing clients into standardised propositions without sufficient consideration of their individual needs. Product governance rules add another layer: advisers and manufacturers need to think carefully about the intended target market and whether products are designed, distributed and monitored with end clients in mind.

The following framework sets out the main areas an IFA should consider before approving a fund or fund manager for inclusion in a client portfolio.

1. Start With the Role of the Fund in the Portfolio

The first question should not be, ‘Has this fund performed well?’ It should be, ‘What job is this fund supposed to do?’

A global equity tracker, a short-duration bond fund, a strategic bond fund, an ESG/ ethical fund and an emerging markets small-cap fund are not competing for the same role. They have different purposes, different risks and different client suitability considerations. Before assessing a fund manager, the adviser should define the intended role of the fund within the portfolio.

Is the fund designed to provide broad market exposure? Is it intended to reduce portfolio volatility? Is it being used to access a specific asset class? Is it expected to provide income? Is it included because the firm believes the manager has skill? Is it there to diversify other return sources? Without answering this first, due diligence can become a vague exercise in reviewing factsheets, star ratings and historic returns.

The role should also be linked to the client proposition. A fund may be perfectly sensible within one centralised investment proposition and inappropriate within another. For example, a concentrated active equity fund may be reasonable in a high-risk satellite allocation, but much harder to justify as a core holding for cautious clients. Similarly, an illiquid alternative strategy may be inappropriate for clients who require flexibility, even if the long-term expected return appears attractive.

2. Understand the Investment Philosophy

A fund manager’s philosophy should explain why the strategy should work. This is different from simply describing what the manager owns.

For an active equity fund, the question is: what is the manager’s claimed edge? Do they believe markets underreact to quality? Do they exploit valuation anomalies? Do they focus on small-cap inefficiencies? Do they have a behavioural, informational or structural reason to believe they can add value after costs? For a passive fund, the philosophy is usually simpler: the fund aims to capture the return of a defined market or index as efficiently as possible. For a systematic or factor fund, the philosophy should explain the evidence behind the exposures being targeted.

A weak philosophy is often vague and outcome-based. It says the manager looks for ‘high-quality businesses at attractive valuations’ or aims to ‘outperform over the long term’, but does not clearly explain why the manager should be able to do this better than the market. A stronger philosophy is specific, repeatable and testable. It links the fund’s process to an identifiable source of expected return or diversification benefit.

This matters because due diligence should not rely on recent performance alone. Recent outperformance may reflect skill, but it may also reflect style exposure, sector exposure, currency movements, leverage, liquidity risk, valuation change or luck. A well-defined philosophy gives the adviser a basis for judging whether the fund is behaving as expected, even during periods of underperformance.

3. Assess the Investment Process

The process is where the philosophy becomes operational. It should explain how securities are selected, how portfolios are constructed, how risk is controlled and how sell decisions are made.

For an active manager, this means understanding the research process. How large is the investable universe? How are ideas generated? What valuation framework is used? How are position sizes determined? How much discretion does the lead manager have? What would cause the fund to sell a holding? How does the team avoid behavioural biases such as overconfidence, anchoring or reluctance to sell losers?

For a passive or index fund, the questions are different. How is the index replicated? Is the fund physically replicated or synthetic? Does it use full replication or sampling? How is tracking error managed? Does the fund engage in securities lending? If so, how is collateral managed, and how are revenues shared between the fund and the provider?

For a multi-asset or risk-rated fund, the adviser should understand the asset allocation process. Is the allocation strategic, tactical or both? What assumptions are used for expected returns, volatility and correlations? Who controls changes to the asset mix? How frequently is the portfolio rebalanced? Does the fund’s risk level map sensibly onto the firm’s client risk categories?

A good process should be clear enough that the adviser can explain it to a client in plain English. If the process cannot be explained, it probably has not been understood.

4. Meet the Fund Management Team

For active and discretionary strategies, meeting the fund management team is a key part of qualitative due diligence. Factsheets and performance data can tell an adviser what happened. A manager meeting can help explain why it happened.

The purpose of the meeting is not to be impressed by a polished presentation. It is to test consistency, discipline and depth of thought. The adviser should ask the manager to explain periods of poor performance, not just periods of success. What went wrong? Was the outcome consistent with the strategy’s expected risks? Did the manager change the process in response? If so, was that a sensible refinement or a sign of style drift?

The meeting should also test whether the manager can explain the portfolio at the underlying holding level. Why are the largest positions held? What risks would cause those holdings to disappoint? How does the manager think about valuation? What would make them change their mind? A credible manager should be able to answer these questions with clarity. A less credible manager may rely on generic narratives and marketing language.

A manager meeting should also cover the commercial direction of the fund. The adviser should ask whether the asset manager is actively trying to grow the fund, what type of investors it is targeting, and whether expected inflows could change how the strategy is managed. A small fund may need to grow to become commercially viable, but a successful fund can also become too large for its opportunity set. The aim is not to penalise commercial success, but to understand whether the fund’s future asset base could look materially different from the one that generated the historic record.

For an IFA, it is also important to document the meeting. Notes should record the key points discussed, any concerns raised, and how the meeting affected the firm’s view of the fund. Due diligence is not just about doing the work; it is about being able to evidence that the work was done.

5. Review the People and Key Person Risk

A fund’s track record does not belong to the name of the fund. It belongs, at least partly, to the people and process that produced it. If those people leave, the relevance of the track record may change.

Key person risk is therefore central to fund due diligence. Who is the lead manager? How long have they managed the fund? Who else is involved in decision-making? Is the strategy dependent on one individual, or is there a broader team? What is the succession plan? How stable has the team been? Have analysts, co-managers or senior investment staff recently left?

This is particularly important for high-conviction active funds, boutique managers and specialist strategies. A passive global equity fund has very little key person risk because the process is largely rules-based. A concentrated active fund run by a single star manager has much more. That does not automatically make it unsuitable, but it does mean the adviser needs to understand and monitor the risk.

There is also a distinction between named-manager risk and organisational risk. A fund may have a strong lead manager but weak institutional support. Alternatively, it may sit within a large, well-resourced firm with deep research capabilities, clear governance and strong operational controls. The adviser should consider both.

6. Consider the Age of the Fund and the Relevance of the Track Record

The age of the fund matters because short track records are difficult to interpret. A fund with two years of strong returns may simply have benefited from a favourable style environment. A fund with a ten- or fifteen-year history gives the adviser more evidence across different market conditions, but even that evidence must be interpreted carefully.

The adviser should ask whether the fund has been tested through a full market cycle. Has it experienced a bear market? A rising-rate environment? A value-led market? A growth-led market? A liquidity shock? A period when its investment style was out of favour? The more limited the history, the more cautious the adviser should be about drawing conclusions.

It is also important to check whether the track record is genuinely comparable. Has the fund changed manager? Has the mandate changed? Has the benchmark changed? Has the fund’s size increased materially? Has the process evolved? A long performance history is less useful if the strategy being assessed today is not the same strategy that generated the historic record.

For newer funds, it may be possible to assess related evidence. Does the manager have a prior record running the same strategy elsewhere? Is the fund a new vehicle for an existing process? Is there a model portfolio or institutional account with a longer history? This evidence can be useful, but it should be treated with care. Backtests, model returns and predecessor fund records are not the same as live, investable performance delivered to clients after costs.

7. Analyse Performance, But Do Not Base the Portfolio Around It

Performance analysis is necessary, but it should not be reduced to ranking funds by three- or five-year return.

A proper performance review should ask what drove the return. Did the fund outperform because of security selection, asset allocation, factor exposure, sector positioning, currency exposure, duration, credit risk, liquidity risk or leverage? Was the return achieved consistently or through a small number of exceptional periods? Did the fund take more risk than its peers or benchmark? Did it perform as expected in difficult markets?

Risk-adjusted measures can help, but they are not perfect. Sharpe ratios, information ratios, maximum drawdowns and downside capture ratios are all useful, but they are backward-looking and sensitive to the period chosen. A fund can look excellent over one period and mediocre over another. The adviser should therefore examine performance across multiple time periods and market regimes.

The correct question is not simply, ‘Did the fund outperform?’ It is, ‘Did the fund behave in a way that is consistent with its stated role, philosophy and risk profile?’ A defensive equity fund that lags sharply in speculative bull markets may be doing exactly what it is meant to do. A cautious multi-asset fund that suffers equity-like drawdowns may not be.

8. Examine Costs and Value for Money

Costs are one of the few variables investors can know in advance. For that reason, they should be central to due diligence.

The adviser should consider the ongoing charges figure, transaction costs, platform availability, bid-offer spreads, performance fees, dilution levies and any other costs borne by the client. For active funds, the key issue is whether the fund has a plausible chance of adding value after those costs. For passive funds, the focus is usually on whether the fund delivers the desired exposure efficiently, with low tracking error and competitive charges.

Cost should not be assessed in isolation. A cheap fund can still be poor value if it tracks the wrong index, has weak implementation or does not fit the client’s objective. An expensive fund can theoretically be justified if it provides genuinely scarce skill or access, but the evidential burden is much higher. The higher the fee, the more confident the adviser needs to be that the fund offers something meaningfully different from cheaper alternatives.

This is also relevant under the Consumer Duty. The FCA’s product governance review emphasised the importance of considering end clients throughout the product lifecycle, rather than treating product design and distribution as a box-ticking exercise.

9. Review Capacity, Liquidity, Fund Size and Plans to Grow Assets

A fund’s size can be both a strength and a weakness. Very small funds may lack commercial viability, have limited resources, face higher costs or be at risk of closure. Very large funds may struggle to implement their strategy, particularly in less liquid areas of the market.

The appropriate size depends on the asset class and strategy. A global large-cap equity fund can usually manage many billions without major capacity issues. A UK smaller companies fund, emerging markets small-cap fund or specialist credit strategy may face capacity constraints much earlier. If a manager’s edge depends on investing in less researched, less liquid securities, asset growth can dilute that edge.

The adviser should therefore understand not only how large the fund is today, but also how large the manager expects it to become. What are the manager’s plans to build the book? Is the fund being actively marketed to platforms, discretionary fund managers, institutions or adviser firms? Is the manager targeting rapid asset growth? Is there a stated capacity limit? Would the fund soft-close or hard-close if assets became too large? How would the portfolio change if the fund doubled, tripled or grew tenfold?

This is especially important for newer or smaller funds. A small fund is not automatically unsuitable. Some strong strategies begin life with modest assets, and early investors can benefit from a manager operating in a less capacity-constrained part of the market. But the adviser needs to understand whether the fund is commercially viable at its current size and whether the manager has a credible plan for growing assets without damaging the investment process.

There is a balance to strike. If the fund remains too small, there may be a risk of closure, merger or rising costs. If it grows too quickly, there may be a risk that the manager is forced into larger, more liquid names, reducing the very edge that made the strategy attractive in the first place. This is particularly relevant in small-cap equities, specialist credit, emerging markets, property, infrastructure, private assets and other less liquid areas.

The adviser should also consider liquidity. How liquid are the underlying holdings? How often does the fund deal? Could the fund meet redemptions in stressed markets without disadvantaging remaining investors? Has the fund ever gated, suspended dealing or used swing pricing? Are there structural liquidity mismatches between the fund’s dealing frequency and the liquidity of its assets?

This is particularly important where daily dealing funds invest in less liquid assets. The fact that a fund offers daily dealing does not mean the underlying assets can be sold daily at fair value in stressed conditions.

10. Assess How Much of the Fund Your Firm Would Own

This is an important but often overlooked point. If an advice firm’s clients would represent a meaningful percentage of a fund’s assets, that creates additional risks for both the adviser and the fund.

If the firm places a large allocation into a small fund, it may become a significant investor. That can create liquidity risk if the firm later wants to redeem. It may also create operational or commercial risk for the fund itself, because a large redemption could force the manager to sell holdings, increase transaction costs or affect remaining investors. In extreme cases, the advice firm could become too important to the viability of the fund.

There is no universal threshold, but the adviser should understand the proportion of fund assets represented by the proposed allocation. For example, an advice firm placing £20 million into a £5 billion fund is unlikely to create a problem. The same allocation into a £60 million fund is a very different situation. The issue is not only the percentage ownership today, but what could happen if the adviser later decides the fund should be removed from portfolios.

This point should be considered alongside the manager’s own growth plans. If the adviser’s firm would initially represent a large share of the fund, but the manager expects to raise substantial assets from other investors, that concentration may fall over time. But that expectation should not simply be assumed. The adviser should ask how realistic the asset-raising plan is, who the likely investors are, and whether the fund has already secured meaningful commitments. Conversely, if the fund is expected to remain small, the adviser needs to be comfortable with being a material investor and should have a clear plan for how any future redemption would be handled.

This should also influence monitoring. If the firm is a material investor, it may need more regular contact with the fund manager, clearer liquidity expectations and a documented exit plan.

11. Check Operational Strength and Governance

Investment due diligence should not ignore operational due diligence. A fund can have a sensible investment strategy but weak operational infrastructure.

The adviser should understand who the authorised corporate director, depositary, custodian, administrator and auditor are. Are these reputable firms? Are there independent checks and balances? Is the fund regulated in a familiar jurisdiction? Are there clear valuation policies? How are pricing errors handled? What oversight exists around risk management and compliance?

For large mainstream UCITS funds, many of these risks may be relatively low, but they should not be ignored. For more specialist, offshore, alternative or less transparent funds, operational due diligence becomes much more important.

The adviser should also review the quality of reporting. Are factsheets clear and consistent? Are holdings disclosed? Are risk statistics available? Does the manager provide meaningful commentary, or just marketing language? Can the adviser obtain timely information when needed? Poor transparency is not always a reason to reject a fund, but it increases the burden of justification.

12. Consider Tax, Platform and Implementation Issues

A fund may be attractive in theory but problematic in implementation.

The adviser should check whether the fund is available on the firm’s preferred platforms, whether the correct share class is accessible, whether income and accumulation units are available, and whether the fund fits within the relevant tax wrapper. For UK clients, reporting fund status, income treatment, equalisation, dividend distributions and bond interest distributions may all matter depending on the account type and client circumstances.

Practical issues also matter. Is the fund easy to trade? Are there minimum investment levels? Are there dealing cut-off times? Does the fund settle in a way that creates cash drag or rebalancing difficulties? Are there restrictions on adviser access? Is the factsheet data compatible with the firm’s reporting systems?

These points may sound mundane, but implementation problems can lead to poor client outcomes. A theoretically good fund that cannot be efficiently accessed, monitored or rebalanced may not be appropriate for the firm’s proposition.

13. Test Suitability Against the Target Client

Fund due diligence should always come back to the client.

Under product governance rules, firms need to consider the target market for financial instruments, including the types of clients for whom a product is compatible and those for whom it is not. The FCA’s MiFID II product governance review focused specifically on how asset managers consider the interests of end clients throughout the product lifecycle. For an adviser, this means asking whether the fund is suitable for the clients who will actually hold it, not just whether it is a good fund in the abstract.

What level of knowledge and experience does the fund require? What risk tolerance is appropriate? What time horizon is needed? Could clients understand the fund’s behaviour during difficult periods? Would the fund create concentration, liquidity or complexity risks that are inconsistent with the client proposition?

This is especially important for centralised investment propositions. The FCA’s FG12/16 guidance addressed replacement business and centralised investment propositions, including concerns around how firms demonstrate suitability when using standardised investment approaches. A centralised approach can be efficient and beneficial, but only if the firm can show why the chosen funds are appropriate for the relevant client segments.

14. Document the Decision

A fund should not be added to a portfolio simply because an investment committee liked the manager or because the fund appears on a recommended list.

The firm should document the rationale for inclusion. This should include the fund’s intended role, the reasons for selecting it over alternatives, the main risks identified, the cost assessment, the target client type, and the conditions under which the fund would be reviewed or removed.

Good documentation protects clients and the firm. It creates a record of the decision-making process and reduces the risk of hindsight bias. If the fund later underperforms, the key question should be whether the original rationale was sound and whether the fund behaved consistently with that rationale. Not every underperforming fund was a bad recommendation. But a poorly documented recommendation is much harder to defend.

15. Set an Ongoing Monitoring Process

Due diligence does not end when a fund is approved. Funds change. Managers leave. Assets grow. Styles drift. Costs change. Performance deteriorates. Better alternatives emerge. Client needs evolve.

An adviser should therefore have a formal monitoring process. This might include scheduled quarterly or annual reviews, performance and risk monitoring, manager meetings, fund size checks, personnel updates, cost reviews and platform availability checks. There should also be trigger events that prompt an immediate review, such as manager departure, mandate change, fund merger, persistent underperformance, large inflows or outflows, dealing suspension, regulatory issues or material changes in portfolio characteristics.

The monitoring process should specifically revisit the fund’s asset base. Has the fund grown in line with expectations? Has growth changed the portfolio? Has the manager moved into larger or more liquid securities? Has cash increased because inflows cannot be deployed quickly enough? Has the fund become more diversified in a way that reduces its active share or distinctiveness? Alternatively, has the fund failed to attract assets, increasing the risk of closure or merger?

The monitoring process should distinguish between tolerable underperformance and thesis-breaking change. A value manager underperforming during a growth-led market may not be a problem. A value manager abandoning valuation discipline to chase growth stocks may be. A short-duration bond fund lagging in a falling-rate environment may be expected. A short-duration bond fund quietly increasing credit risk to boost yield may not be.

The purpose of monitoring is not to constantly replace funds. Excessive turnover can be damaging, costly and behaviourally driven. The purpose is to make sure the original rationale remains valid.

Conclusion

Fund due diligence is not about finding perfect funds. No such funds exist. It is about building a disciplined process that helps advisers understand what they are recommending, why they are recommending it, what risks are being accepted, and whether those risks are appropriate for the client.

The best due diligence frameworks combine quantitative analysis, qualitative judgement and practical implementation checks. They consider performance, but do not rely on it. They meet managers, but do not confuse confidence with evidence. They examine costs, but do not assume cheapest is always best. They consider fund size, liquidity, key person risk, operational resilience and client suitability. They also consider the commercial future of the fund: whether it can survive at its current size, how the manager intends to build assets, and whether future growth could damage the strategy.

Most importantly, advisers need to document the reasoning and monitor the decision over time. For an IFA, this is not just good investment practice. It is part of acting in clients’ best interests. A fund recommendation should be capable of being explained, evidenced and reviewed. If an adviser cannot clearly say what a fund is for, why it was chosen, what could go wrong, and what would cause it to be removed, the due diligence is probably not yet complete.

Practical Due Diligence Checklist

Before approving a fund, an IFA should be able to answer the following questions:

1. What role does the fund play in the portfolio?

2. Which client segment or risk profile is it intended for?

3. What is the fund’s investment philosophy?

4. Is the process clear, repeatable and consistent with the philosophy?

5. Who makes the investment decisions?

6. How significant is key person risk?

7. How long is the live track record, and is it relevant?

8. Has the strategy been tested through different market environments?

9. What has driven historic performance?

10. Has the fund behaved as expected during difficult periods?

11. What are the total costs, including transaction costs and any performance fees?

12. Is there a cheaper or simpler alternative that achieves the same objective?

13. How large is the fund?

14. Could the fund be too small to be commercially robust?

15. Could the fund be too large for its strategy?

16. What are the manager’s plans to grow the fund?

17. Is the fund being actively marketed to other advisers, DFMs, platforms or institutions?

18. Is there a stated capacity limit?

19. Would the manager soft-close or hard-close the fund at a certain size?

20. How would the portfolio change if assets grew significantly?

21. What percentage of the fund would the advice firm’s clients represent?

22. Would the firm be a material investor in the fund?

23. Could the firm exit without disadvantaging clients or remaining investors?

24. Are the underlying assets sufficiently liquid?

25. Are there any dealing, settlement or platform issues?

26. Who provides custody, administration, depositary and audit services?

27. Is the reporting transparent enough for ongoing monitoring?

28. Does the fund align with the manufacturer’s target market?

29. What would cause the firm to place the fund on watch?

30. What would cause the firm to remove the fund?

31. Has the rationale been documented clearly enough for a compliance file?

32. How often will the fund be reviewed?

References

Financial Conduct Authority. 2012. Assessing Suitability: Replacement Business and Centralised Investment Propositions. Finalised Guidance FG12/16.

Financial Conduct Authority. 2016. Assessing Suitability: Research and Due Diligence of Products and Services. Thematic Review TR16/1.

Financial Conduct Authority. 2021. MiFID II Product Governance Review.