I find it fascinating when, over the course of just a few months, I see a consistent theme emerge in my conversations with discretionary fund managers (DFMs) and advisers. Most recently, the challenges of risk profiling and suitability have taken centre stage.

What’s driving this? I can point to several things: MiFID II and the requirement for 10% drop reporting; the FCA’s focus in this area; and the exponential growth in discretionary models available on platform.

In a recent conversation with Robert Clark, head of sales and marketing at RC Brown, we spoke about how his firm has implemented 10% drop reporting and, most importantly, how clients have responded.

Robert said:

“We’ve refined our reporting process and streamlined the way we communicate drops to advisers and their clients. I’m pleased to say it is now a well-oiled machine, thanks to the market volatility in December.

Regarding the response from clients, it’s been interesting. Where the adviser has had a quality conversation with the client from the outset of the relationship, there are no surprises. The client understands why they hold their portfolio and that markets will fluctuate over the lifetime of their investments.

If a client ‘blows up’ (that’s such a visual label), it’s usually because the opposite is true. These clients don’t feel they’ve been kept informed or that the communication around their investments has been adequate. This is  a delicate area, as we don’t want to be treading on the adviser’s toes or complicating the relationship with their client, but inevitably the client contacts us directly for clarification.”

To me, this begs two questions. Firstly, are these clients invested in line with their risk profile and appetite for loss? Secondly, is their portfolio suitable?

The regulator has a number of concerns about suitability: from how suitability reports are written, the use (and misuse) of risk profiling tools, and how these tools are mapped to investment portfolios.

The FCA’s Finalised Guidance FG11/5 Assessing suitability: establishing the risk a consumer is willing and able to take and making a suitable investment selection listed the following concerns:

» Over-reliance on risk profiling and asset allocation tools, without actively managing the limitations of such tools

» Poor descriptions of attitudes to risk

» Failing to accurately map the client’s risk profile to a product or portfolio

» Inappropriate focus on the risk a customer is willing to take without sufficient consideration of their other needs, objectives and circumstances (like the need to repay debt)

 

Advisers I speak with are often surprised to learn that using a risk profiling tool is not a regulatory requirement.

 

The FCA’s guidance in FG11/5 clearly states:

“We do not prescribe how firms establish the risk a customer is willing and able to take, or how they make investment selections, accepting that firms should give due consideration to the nature and extent of the service provided.”

The benefit of using tools is that they can aid discussions with clients, as well as bringing structure and consistency to the process. However, they are not without their limitations – unless these are mitigated, the results can be flawed.

Writing in Nucleus’ recent white paper on suitability, Yellowtail Financial Planning director Dennis Hall noted the importance of having face-to-face conversations with clients about risk. His comments struck a chord with us:

“Our approach is to measure clients’ attitude to risk frequently, but feel that part of our job is also to downplay the importance of volatility and talk to people about risk in terms of more predictable and sustainable outcomes over an appropriate and relevant timescale.”

It’s worth noting that several of our DFM partners have shown an aversion to using standard tools. One said:

“We don’t risk-rate or grade anyone, and we don’t understand why our profession feels the need to put clients in boxes. Our approach is to have a meaningful discussion about risk tolerance and capacity for loss. We explain how our proposition will perform in different market conditions and steer clear of shoehorning clients. If they don’t like our approach or they’re not willing to take the risk, we turn them away.”

Another agreed, and said:

“We’ve looked at most of the main risk profiling tools, but we don’t agree with their articulation or measurement of risk. Risk can be very subjective, so we’ve created our own. We have removed the jargon and ensured the risk category descriptions are clear and not misleading. We also don’t use numbers to denote different categories of risk, because these can be very subjective.”

Adding platforms to the mix adds further complexity, although the issues of suitability and DFM portfolios on platform is a subject that warrants an entire article, so I’ll leave it there for now!

All of this underscores the value of face-to-face and jargon-free conversations with clients to foster a deep understanding of risk (in all of its guises, including the risk of not meeting a goal if risk is taken off the table) and capturing what it really means for them. You may find that risk-profiling tools can assist these conversations, but they certainly can’t be used as a substitute.

 


The inspiration for this DISCUS article was a conversation with Robert Clark of RC Brown on MiFID II and how clients are responding to the 10% drop reports. To find out more about RC Brown please visit their dedicated page here.