This paper highlighted that establishing the risk a customer is willing and able to take and then making a suitable investment selection as being critically important.
Risk profiling done well helps advisers take a big step towards creating a compliant investment process and proposition that is aligned with this requirement. It can also provide a robust framework by which the adviser or firm can charge ongoing fees in return for ensuring that the investment remains suitable over time for its customer.
As risk profiling has evolved, so have the standards for ensuring it is done well. It is clear that the FCA is now not only looking at how a client is profiled, but also whether the investment is profiled on a consistent basis, both at the time of advice and, if an ongoing service and fee is in place, over time too. As a result, creating a successful and compliant process increasingly depends upon the integrity of the asset model employed throughout the process. For example does the model analyse the client’s existing assets on a consistent basis with future recommendations? Are the same asset class and assumptions applied? Is the model consistent with the way in which the customer’s risk profile is generated? Does the ongoing process use this same model and if investments are held on a platform or platforms, are the underlying data feeds and asset classifications consistent? We call this asset model integrity.
Assessing how a customer feels about risk is typically achieved through the use of a psychometric questionnaire and this provides a sensible starting point. However, the questionnaire should not be used in isolation as further assessment of the customer’s unique characteristics, for example their time horizon also needs to be determined. Some questionnaires amalgamate, or ‘conflate’ multiple personal characteristics (for example, term, liquidity, capacity and existing wealth) through a quantitative algorithm. Conflation of these differing risk factors in this manner runs the risk of providing inappropriate investment recommendations as it potentially loses sight of what the customer’s underlying attitude to risk truly is. Conflation was a key concern raised in the FSA’s suitability paper and is best assessed in a consultative way between the adviser and the customer. The discussion around how a customer feels about risk can also be helpfully enhanced through a discussion around ‘value at risk’, that is, the actual amount a client feels comfortable potentially losing (which is different from their actual capacity, that is, ability to sustain a loss) and confirming the type of ‘investment journey’ they feel comfortable with in plain English and with graphics so that the customer can sign up to this.
Once the customer’s risk profile has been established suitable investments can be aligned through a fund or portfolio risk-profiling service. Not all risk-profiling solutions assess risk on the same basis; some look at the volatility of historical performance (ex-post), others look to the future and create an expectation of portfolio risk (ex-ante), while others attempt to factor in an investor’s term into its calculations. It is therefore vitally important that the methodology employed is understood, well documented and calculated in a manner consistent with the risk profile.
Fund risk profiling has become especially important for multi-asset products. To give an example of why: a fund that conforms to the IMA Mixed Investment 20 per cent to 60 per cent shares sector could, as the name suggest, hold anywhere from 20 per cent to 60 per cent in equities. But the non-equity asset classes employed, potentially 40 per cent to 80 per cent of the fund, are not risk free and could span anywhere across the expected risk spectrum.
It is possible to illustrate the range of expected volatilities for monthly asset allocation data points, applying a fixed set of volatility and correlation assumptions. Over five years this particular fund potentially doubled its ‘risk’ but still remained within its sector. The point here is not to criticise the sector classifications but to highlight the opaqueness that can exist within a multi-asset fund. Once an investment into a multi-asset product has been made, control over the asset allocation has been delegated to the fund manager. This means that an adviser’s ability to keep control of a customer’s expected portfolio risk has been greatly diminished. If the adviser has an ongoing duty of care to his or her customer to ensure the suitability of their investment and is taking an ongoing fee for doing so, clearly understanding its changing risk profile is vital. Regular fund risk profiling, linked on a consistent basis to the customer’s attitude to risk is key to ensuring ongoing suitability.
A further reason why fund risk profiling is important is that each fund manager will have their own methodology for calculating fund volatility and construction of portfolios – there is no industry standard. A fund risk profiling service that uses a consistent asset model across all funds can distil these approaches back to a single ‘language’ of risk – helping the adviser apply this to his customers to make suitable, compliant recommendations with integrity.
Fund risk profiling is not without risks however and should by no means be considered a guarantee of future success or indeed an endorsement of a particular fund. There are of course many non-quantifiable events that can, and do occur in the market that can greatly affect the running of a portfolio or fund – such as a fund manager or team departure, a merger/acquisition or even financial difficulties at the fund management group level for example. All of these qualitative factors are equally important and need to be considered when giving investment advice.
Chris Fleming is the financial analytics director of Distribution Technology
Key points
Interest risk profiling has picked up over the last two years since the release of the City regulator’s Assessing Suitability Paper.
As risk profiling has evolved, so have the standards for ensuring it is done well.
Fund risk profiling is not without risks however and should by no means be considered a guarantee of future success or indeed an endorsement of a particular fund
