Perils and pitfalls of risk profiling
Communicating asset class performance and the relationship between risk and reward is key to investing client funds
Last month, the FSA published the much-anticipated Retail Conduct Risk Outlook 2012. In it, the regulator sounded several alarms on mis-selling and identified risks related to separate services advisers provide for their clients and, very helpfully, their rationale on why they identified them.
One line of the 124-page document on the mis-selling risk posed by absolute return funds caught my eye: “Financial advisers may not fully understand these products, which increases the possibility that poor communication of investment risks contribute to mis-selling to consumers.”
To me, this is a clear statement from the FSA that they are still concerned too many advisers do not fully understand what is behind the investment products they offer clients. It is certainly not just about absolute return funds - it is also about the fund-of-funds that incorporate them and the wider investment universe.
It is about the depth of research and knowledge required by an adviser where they are recommending any investment solution. Managing any business requires control of revenue, costs and business risk. This is an area of particular risk for those without the resources or skills to undertake research effectively.
It is jarring to note that one full year since the FSA launched its risk profiling tools report one-in-five advisers were still not aware the guidance exists
Advisers are increasingly required to be able to clearly separate – and continue to differentiate – the normal, acceptable risk of fund value fluctuations from the unacceptable risk that a client’s investment journey is not right for that individual.
There is not a universally appropriate definition of customer risk. As highlighted in the FSA guidance for Assessing Suitability, published last year, one of the key undertakings of a financial adviser is: “Establishing the risk a customer is willing and able to take and making a suitable investment selection.”
It is jarring to note that research one life office carried out in January this year (that is, one full year since the FSA launched the report) discovered one-in-five advisers were still not aware that the guidance exists. It is also important to note that clients are exposed to many different risks, the relative importance of which depends upon their own personal circumstances.
When assessing the risk of a fund proposition, which will be used as a starting point for alignment of a fund recommendation to a customer risk profile, the risk metric used must be appropriate to the risk to which the customer is exposed, rather than the risk to which the fund manager is exposed.
This means the fund manager has agreed the risk parameters with the adviser as a measure of client risk tolerance rather than having to complement an in-house discretionary or multi-manager proposition.