An investor with a risk score of five can be matched to a product risk-rated as a five, right? Wrong...
Guess the word: Consumers can discover they have a tolerance of it, while a relatively new tranche or products have been built with it in mind. Got it yet?
‘Risk' was always the front runner to become the latest buzzword in retail financial services. But efforts to master the concept and apply it to financial advice have proven difficult: while risk profiling tools and risk-mapped investment solutions were meant to make things easier for advisers, they have introduced a new set of complications.
The problem for advisers can be summed up thus: One product risk-mapped as, say, five, might not be appropriate for a customer with the same risk score. What can advisers do?
The problems posed by risk-rated solutions
The Financial Conduct Authority (FCA) recently stated that advisers must not rely on risk-mapping scores alone to source suitable investment products for their clients.
FCA technical specialist Rory Percival said at a recent conference that the so-called ‘shoehorning' of clients into risk-rated solutions was unacceptable, and that advisers must apply adequate due diligence to check product suitability.
"If [a client] has a tolerance for loss that's a ‘three' and you've got a portfolio that's also a three," he said, "it doesn't necessarily follow that it's right [for the customer], because there are other factors that need to be taken into account."
This apparent ‘shoehorning' of risk-scored clients into risk-rated funds – usually multi-asset or multi-manager funds – has emerged as an unwelcome by-product of the recent proliferation of risk-profiling tools in financial advice. Price pressures brought on by the introduction of new rules following the Retail Distribution Review (RDR), or a misunderstanding of how the risk-rating process works, have been cited as possible reasons for this behaviour.
Defaqto chief executive Zahid Bilgrami said the rise of risk assessments has added to firms' compliance burdens.
"The problem arises if a mandate is collapsed into a score and then there is a mismatch between the score of the mandate and the score of the solution," Bilgrami said.
Advisers must be confident that the score reflects their clients' mandate, and they can't take providers' risk scores at face value because, in the eyes of the regulator, they qualify as opinion, not fact, he added.
Matching risk-profiled clients with suitable solutions is where "the trail goes cold", said Pilot Financial Planning managing director Ian Thomas. He said there was plenty of science around risk profiling but very little evidence-based research on how to match profiles with solutions.
Thomas said he did not believe advisers were knowingly shoehorning clients into potentially unsuitable products, but that conflicting and inconsistent ratings made the process that much harder. For instance, he said he had noticed a high level of variation in the risk and return profiles of funds, even though many sit in the same Investment Management Association sector.
"It's just like a scattergun," Thomas said. "They are all in the same sector and they are all called balanced funds, yet their risk and return profiles are completely different."
Similar problems emerge when using different proprietary tools as risk profilers, he added. Thomas said he once compared the recommended asset allocations of four different providers for the same risk-rated client, only to find that all four had been made up completely differently. One recommended holding twice as much in international equities and half as much in fixed income as another.
"If you are using lots of different proprietary tools you haven't got any kind of consistency at all. That's got to be a risk. You need a system, some way of linking some reality back to the clients to make them aware of what they are buying and so you know what you're buying."
Protect & Invest director Michael Roberts said risk rating worked fine with some solutions but, with others, attempting to match a client's numbered risk rating with a product can seem like "trying to put a square peg into a round hole".
The problem becomes apparent, he said, when the client questionnaire determining the client profile delivers a risk rating of scores between one and five, whereas providers' products are often rated between one and seven or, less commonly, one and ten.
What it boils down to, said Roberts, was understanding in full the products your clients may end up invested in. "There are various options available [to risk-map a client], so advisers have got to make sure they fully understand the products they are using," he said. "If they don't understand them, I'd say that, arguably, they shouldn't be recommending them."
According to Oxford Risk chief executive Terry Thomson, there is an inherent problem with expressing risk ratings in numbers. A plain score of, say, four, he pointed out, was perhaps an oversimplification that can mislead advisers into thinking they have found a match. The problem, Thomson said, was that advisers do not understand how the figures are derived and, therefore, how they should be interpreted. As a result, they might take a five for a five, when it means something different, he said.
"When you are risk rating portfolios based on assets and asset classes, you have got to go into it in substantial depth to understand what the risk rating really is. Unless, of course, the provider is giving you a series of parameters to which they guarantee they are going to manage that particular portfolio. And, of course, quite a lot of them don't," he said.
Often providers exercise judgements hoping to make gains for the customers, he suggested, but they are reluctant to publish strong figures about potential gains and likely future risks.
"We think that some of the approaches to doing this owe more to the fact that there is a desire to make the process of assessing customers' preferences and coming up with suitable solutions as simple and as straightforward as possible and that sometimes that's just oversimplifying it," he warned.
That oversimplification of product ratings, Thomson suggested, will be a future area of concern for the FCA, which will be looking to make sure there is "some sense and consistency" in the way providers risk rate their products.
What the FCA's Rory Percival said
Percival was speaking at the Defaqto DFM conference in October
Capacity for loss
Percival described capacity for loss as a client's ability to withstand losses without materially affecting their standard of living. It is different, he said, to attitude to risk because it is an objective issue – a ‘numbers' thing – as opposed to a subjective ‘feelings' thing. On good practice, Percival said all clients should be assessed independently. He also pointed to lifetime cashflow analysis and ‘scenario planning'.
Asset allocation tools
Advisers, said Percival, need to understand how they work and when to use them. Use tools, by all means, but remember they have limitations and will not give you the right answer in every circumstance. Advisers' responsibility, he said, is to understand how to apply them in an appropriate manner. "We would expect firms to remain broadly competent so they can give outputs a sense check," he said.
Mapping exercises are an area of concern for the FCA, Percival said. What is advisers' understanding of a client's risk profile, what is the risk rating of the fund, and do those map together? Advisers need to do that thinking, he said. Life is not so simple that a tolerance for loss of ‘three' matches a portfolio rated as a ‘three'. Other factors needs to be taken into account, such as clients' knowledge and experience, and the term of investment. "By all means have risk-rated funds but be aware of the context in which they are recommended and whether they are relevant to individual clients," he said.
Percival said he was "concerned" about clients having a number as the only definition of their risk tolerance. Percentage in isolation as a client's risk description would be equally problematic, he added, because advisers would not then have a broader idea what level of risk that client is willing and able to take.
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