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Ensuring ongoing investment suitability

FCA focus on whether investment recommendation is profiled on a consistent and ongoing basis requires advisers to employ a robust asset model, says Ben Goss, chief executive of Distribution Technology

Risk profiling has gained significant momentum over the last two years on the back of the then FSA’s Assessing Suitability Paper of January 2011. 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 helps advisers take a big step towards creating a scalable, centralised investment process that can be aligned to key customer segments. It also provides a robust framework by which the adviser or firm in a post RDR-world can charge ongoing fees in return for ensuring that the investment remains suitable over time for the customer.

As risk profiling has evolved so too have the standards for ensuring it is done well.

For individual customers, risk can be viewed as uncertainty of capital return. The widely used measure of volatility is not necessarily a good single proxy for this risk.

Therefore measuring customer attitude to risk needs to be considered much more thoroughly and this is where the regulatory thinking is firmly positioned both in the UK and via MIFID2 across Europe.

Understanding a client’s risk tolerance
Risk tolerance – how a customer ‘feels’ about accepting risk – needs to be understood and is typically assessed via a psychometric risk questionnaire. This helps establish whether the customer has the mental aptitude and desire to pursue a potentially more profitable outcome with his savings at the risk of a less favourable one. This process can be helped through a ‘value at risk’ analysis i.e. the actual amount a client feels comfortable potentially losing and confirming the type of ‘investment journey’ they feel comfortable with in plain English and with graphics so that the customer is properly engaged.

The following chart shows the output from the 20 multiple-choice psychometric questionnaire that resides within Distribution Technology’s core product Dynamic Planner. The results cover c50,000 responses and show that the distribution of the output is broadly following the familiar ‘normal’ shape (bell curve) – as it was designed to do – with most respondents falling into the middle risk category.

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However, a psychometric assessment of risk should not be used in isolation and it is vital to understand the customer’s other unique characteristics. For example, what impact a capital loss would have on their standard of living and whether they are financially able to bear any related investment risks – referred to as risk capacity. This is often carried out via full cash flow analysis that then can assess the probability of failure or success in meeting goals via a stochastic model. Other factors that need careful consideration are time horizon, liquidity needs, knowledge and experience.

Some questionnaires amalgamate, or ‘conflate’ multiple personal characteristics via 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.

Asset model integrity
It is clear that the FCA is now not only looking at how a client is risk profiled, but also whether the investment recommendation is profiled on a consistent basis, both at the time of the initial advice and as part of the ongoing service.
As a result, creating a successful and compliant process increasingly depends upon the robustness and consistency 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 single or collection of platforms, are the underlying data feeds and asset classifications consistent? We call this asset model integrity.

Once a risk budget has been agreed with the customer, suitable investments can be aligned via a fund or portfolio risk profiling service, harnessing the benefits of the asset model integrity.

However, it is important to realise that 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), whilst others attempt to factor in an investor’s time frame into its calculations. It is also important to understand that some funds are mapped specifically to a given risk profiling service whilst others are agnostic and simply apply a profiling score.

As an example, there are currently over £2 billion of assets which are managed with specific reference to Distribution Technology’s risk model assumptions. These consist of both funds and discretionary managed portfolios and are often called risk targeted, or risk mapped. As a result, they are managed not to change risk profiling score in the future. However, there are others that simply apply the profile score and fully accept it could change in the future – such funds are often called risk profiled, and hence not targeted.

At Distribution Technology we map a clients’ capacity and willingness to take risk, to a set of appropriate portfolios that are frequently monitored – thereby creating a consistent and simple framework upon which an adviser can assess customer suitability.

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Fund risk profiling is not without risks and should by no means be considered a guarantee of future success or an 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 fund management group level. All of these qualitative factors are equally important and need to be considered when giving investment advice. For this reason it is important that fund risk profiling is not used in isolation.

In conclusion, risk profiling services from both a customer and investment perspective are powerful tools to ensure initial and ongoing suitability. If delivered via efficient and cost saving technology, adviser firms can tailor their service propositions to differing customer segments in a much more sustainable way and tackle head on the challenge of accessibility to quality advice.

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