At an FTAdviser seminar this morning on due diligence and suitability assessment of multi-asset funds, Andy Gadd, head of research at Lighthouse Group, bravely took up the challenge of defining ‘appropriate due diligence’ to the packed room of delegates.
In particular he focused on the expectations - and outcomes - of the regulator, as part of its own ‘outcomes-based’ approach. In essence, this means simply that the regulator is “fairly loose” on the machinations of your advice process, as long as the outcomes are in the client’s best interest.
All sounds very reasonable - and simple - in theory. And he went on to make some more statements on the FCA approach that sounded equally proportionate and intuitive.
For example, he stated that any adviser worth his or her salt should not recommend any investment that they do not “fully understand” themselves (helpfully referencing little understood underlying complexity and illiquidity of the Arch Cru funds that have become a spectre hanging over the advice industry).
Mr Gadd admitted, however, that there is a fly in the ointment: while it is desirable, it is not always viable to get to grips at a granular level with investments that you may otherwise feel you have enough of a handle on to recommend.
He cited with-profits bonds, stating that while many advisers including himself had recommended them in the past, few would be able to fully articulate how the bonuses and returns were calculated.
Similar concerns have been raised in relation to, for example, structured products.
Most advisers may feel they comprehend how a given product is designed to operate and the unique risk factors - such as counterparty risk - involved, but they may not understand “fully” how the underlying put and call option derivatives work. Should they on this basis recommend the product?
The panel session at the end of today’s session was dominated by this discussion specifically in relation to Invesco Perpetual’s new major multi-asset offering, the Global Targeted Returns Fund.
The vehicle, which has recently launched on 3 November, is described as a “fund of ideas”. It comprises at the moment of 24 ‘ideas’ of where returns might be found based on a central macroeconomic hypothesis, which are then implemented via a wide range of strategies.
Using this methodology, the fund aims to generate a 5 per cent return above Libor on a rolling three-year annualised basis, but with half the volatility on the MSCI World equity index.
Not surprisingly, that sounds appealing. The questions begin to come around assessment of the fund when you look beneath the bonnet at the underlying investment themes and how they are “expressed”.
At one end of the scale you have the idea that European equities currently offer good value over a medium-term horizon and will therefore generate positive returns over two to three years. This has resulted in the fund investing in a couple of Invesco’s own European equity funds.
At the other end of the complexity scale you have the idea that Australian interest rates will remain lower for longer than current market pricing would indicate, which the fund accesses by investing in ‘two-year, two-year’ Australian rate futures.
Other ideas involve buying into volatility on the Hang Seng China Enterprises Index, or using equity put derivatives as a proxy for long equity exposure.
While it is desirable, it is not always viable to get to grips at a granular level with investments that you may feel you know enough to recommendConfused? I thought so.
A question from the audience summed up the conundrum for advisers: do they have to “fully” understand and be able to perform due diligence on each of these underlying 24 portfolio elements in order to be confident enough to recommend the fund?
Andy Gadd said simply that the regulator would expect you to be able to justify the due diligence process you used, especially if the fund did not achieve its objectives or if clients lost money.
Ian Trevors, head of distribution at Invesco, responded that from direct conversations with the regulator you would only need to understand in broad terms how the investment approach worked and how risk was defined within the fund.
He said that just as you do not need to look at each underlying security in an equity portfolio in order to recommend the fund, so in this case you would only need to understand the fund’s strategy and how the managers select each investment.
In principle I agree with them both. The fund sounds relatively simple to grasp in principle and as long as the adviser is confident they understand how to assess the risk and can explain this to the client all should be well.
On the other hand, while this may appease the FCA, the sentiment emanating from the audience was one of concern that not understanding the minutiae of the underlying portfolio could leave them exposed to complaints, which Mr Gadd himself said were rising and likely to continue to do so in the future.
This reflects the reality that it is increasingly not the regulator but quasi-regulatory bodies such as the Financial Ombudsman Service that advisers need to worry about.
If Fos were to assess a complaint into advice on this fund - or, say, a structured product - in the event of client losses, I wonder how they would assess any advice process if the adviser admitted to not knowing how the underlying investments operated.
So, how deep down the rabbit hole should you go? I’d be interested to hear your thoughts.
