Technology consultancy AT8 assesses what last week's FSA warning on investment selection means for you.
The FSA has been concerned for some time about the approaches used by advisers to determine customers' attitude to risk and to selecting the appropriate investment solutions - including, but not limited to the use of tools.
The FSA ‘Financial Risk Outlook Retail Intermediaries Sector Digest' (March 2010) and the Platform Consultation Paper CP10/29 produced in November 2010 referred to the concern in the wider market use and specific context of Platforms.
The FSA promised to publish the Guidance Paper at the start of the New Year, so it is a timely output given some of the past delays we have seen from the FSA during 2010.
The Paper is relatively short: 25 pages, reasonably easy to read and quite succinct. Although as ever, the FSA says that it is NOT telling the industry HOW to carry out Client Risk Assessments or investment selection but it does contain some good and bad practice examples based on its review experience so far.
One quote from the paper that illustrates how serious the subject is being taken is: ‘As we apply our intrusive and intensive supervisory approach, we will be looking to see how firms have acted on this report.'
So, be warned, the contents of the guidance are important for advisers, discretionary managers, tools and technology suppliers as well as for Platforms.
The FSA looked at a number of issues including:
• Methodologies and Risk profiling tools
• Investment selection processes and asset allocation tools
It looked at files between March 2008 and September 2010 of which over half - some 366 cases - were judged to have failed suitability tests when looking at ‘customer outcomes'. Of those reviewed 199 were judged to have failed because the investment selection did not meet the client's attitude to risk.
The FSA also looked at 11 risk profiling tools of which nine had weaknesses that could cause flawed outputs.
Amongst the findings:
There was a failure to properly assess the risk a customer was willing to take.
• There was inadequate account taken of the customers capacity for loss
• Questionnaires had poor question and answer options, with vague descriptions, definitions and potentially over sensitive weighting being applied
• There was inadequate attention applied to identify weaknesses in processes and provide appropriate solutions including further qualification questions to validate answers that had been provided
• Poor explanation and understanding by advisers and clients of how the methodologies and/or tools worked
Clearly, the level of failure found in the review is unacceptable.
In addition to a description of the approach that the FSA review followed, there are three key sections to the guidance paper:
• Establishing the risk a customer is willing and able to take
• Investment selection
• Adopting third-party tools
Establishing the risk a customer is willing and able to take
Firms shouldtake reasonable steps to ensure that a personal recommendation, or decision to trade, is suitable for its customer:
• collect and account for all the information relevant to assessing the risk a customer is willing and able to take.• assess a customer's capacity for loss (in a way they can understand)
• is such that the customer is able financially to bear any related investment risks consistent with their investment objectives
• is such that the customer has the necessary experience and knowledge in order to understand the risks involved in the transaction or in the management of their portfolio
• identify customers that are unwilling or unable to accept the risk of loss of capital and may be best suited to placing their money in cash deposits
• avoid using vague, unclear or misleading descriptions or illustrations to check the risk that a customer is willing and able to take
• Avoid over simplification such as using a 1 to 10 rating scale which can be open to different interpretation
• Avoid questions that have two elements that could result in an answer for one without taking into account the other element
• Beware of having very wide categories as the risk range could result in an inappropriate investment being selected for the customer
• Avoid combining assessments of a customer's attitude to risk with their capacity for loss
• Ensure that there is clarity and consistency of understanding in interpretation of questions, answers and meaning between the adviser and customer (and the tools/methodology provider)
• understand the investment objectives of a customer including the timescales and purpose of the investment - different investment objectives may have different levels of risk tolerance.
Using risk-profiling tools
Advisers and Discretionary managers must remember that they are responsible for assessing the customer's attitude to risk. Tools can help, but they may not provide the right answer in all circumstances and should not be relied on as the sole means of assessment of a customer's attitude. Indeed, it is the skill and experience of the adviser that can probe the answers being given and to check any conclusions as well as to explain the methodologies being used.
Advisers need to evaluate the tools that they use in relation to their customers and satisfy themselves that it is fit for purpose.
The FSA provides a number of examples of ‘Good' and ‘Poor' practice used to establish the risk a customer is willing and able to take and firms should look at these in the context of judging the suitability of their own firm's current methodologies and practices.
Having looked at how firms establish the risk a customer is willing and able to take the FSA guidance paperexamines how firms then select investments for a customer to meet their objectives
Some of the key concerns were that firms should:
• take appropriate account of all aspects of a customer's investment objectives and financial situation (including the risk they are willing and able to take) as well as their knowledge and experience
• challenge cases where automatically generated investment selections (for example, from model portfolios or asset-allocation tools) are unsuitable for individual customers
• ensure recommendations or transactions are consistent with the risk description confirmed with and understood by the customer
• avoid relying solely on volatility as a proxy for risk
• recognise the importance of considering diversification
• ensure that they fully understand the nature and risks of products or assetsselected for customers
• identify mismatches between a customer's risk attitude and whether this will affect the ability to meet their objectives
• be aware that if none of the investment selections that are available to the firm are suitable for the customer, no recommendation or transaction should be made
• be aware of , inflation risk, liquidity risk, the risk arising from a lack of diversification or specific risks associated with the features of some types of product including its structure, such as counterparty risk
• be able to adjust/tailor the results of automated selection methodologies and tools (such as model portfolios) to ensure that the customer's needs are suitably met, but to also ensure that appropriate supervision and controls are in place to avoid inappropriate changes being made.
Adopting third-party tools
There is an increased reliance on using automated asset allocation tools and model portfolios - something which the FSA acknowledges can be a useful aid.
However, they expect the use of automated solutions to be part of a robust suitability process.Whether using ‘in-house' or ‘off-the-shelf' third-party tools it is the responsibility of the firms providing the advice or discretionary management that remain responsible for assessing suitability as part of the risk a customer is willing and able to take.
If a firm uses a third-party tool to help make suitability assessments for their customers, they should:
• understand how the tool works, so it can interpret and evaluate the results when it is applied to individual customers
• understand to what extent the tool will help meet its regulatory requirements
• ensure that the tool is suitable for use with its customer base
• have a robust process to mitigate shortcomings or limitations of the tool
• where an asset-allocation or fund-selection tool suggests investment selections, to understand the product, market and asset risks for these investments.
Providers of third-party tools should:
• ensure the tools perform as intended and as described to the firms that use them
• providing supporting information to firms that will use the tools, so that they can understand
• any limitations of the tool, including any circumstances for which the tool should not be used
• any assumptions relevant to the use of the tool, for example, about the advice or discretionary management process or target market
• ensure that supporting information is clear and easily accessible.
There are many factors that need to be taken into account when assessing customer attitude to risk and selecting appropriate investments to meet the needs and objectives of customers. Technology and supporting methodologies are increasingly being used to assist the ‘know your customer' and advice process.
The Guidance Paper has recognised the importance of assessing risk and has clearly found that more needs to be done by the providers and users of solutions - the wider Practice Management vendors, specialist tool providers, and the adviser community. We expect to see a sharper focus on how the methodologies and tools work as well as how they are used. We are currently reviewing the platform market but will be turning our attention to the ATR and Asset Allocation tools as the effects of the Guidance is absorbed and changes are made.
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