The FSA says adviser firms' over reliance on risk profiling and asset allocation tools could lead to serious customer detriment and warns it will take tough action on companies failing in this area.
In a guidance paper out today, the FSA said the level of failure in firms' investment selections is "unacceptable" and identified use of model portfolios and over reliance on risk profiling and asset allocation tools as particular areas of concern.
Of the 11 risk-profiling tools reviewed, the FSA said nine had "weaknesses which could, in certain circumstances, lead to flawed outputs".
The paper says: "We expect all types of firms to consider whether they need to improve the way they assess and check the risk a customer is willing and able to take and so ensure they make suitable investment selections.
"We encourage providers of risk-profiling and asset-allocation tools to take action to address any potential weaknesses in their tools."
The FSA says of investment files assessed as unsuitable between March 2008 and September 2010, half were rated as unsuitable on the grounds the investment selection failed to meet the risk a customer is willing and able to take.
The regulator warned some firms are using volatility as the sole risk measure on model portfolios and asset allocation tools and urged firms to take account of other measures of risk, such as underlying assets in a funds or risk arising from the product's structure.
It said factors such as inflation risk, liquidity risk, risk arising from a lack of diversification or counterparty risk need to be considered.
The regulator said using such a narrow set of criteria to establish risk could result in considerable customer detriment.
"We are particularly concerned that, where firms use volatility as a proxy for risk and ignore other risks, this can result in investment selections that, for example, include complex assets that are not suitable given the risk the customer is willing and able to take," it said.
Furthermore, the FSA said firms need to consider the benefits of diversification in terms of both product and asset class and said a lack of diversification can increase risk for the client.
In an ominous warning to firms not coming up to scratch it says: "The level of failure in this area is unacceptable. We have taken, and continue to take, tough action to address these failings with individual firms."
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