At our recent event we asked Eric Armstrong, Head of Product Proposition and Marketing at Synaptic Software to provide a practitioner’s view of due diligence for discretionary investment services. In his presentation Eric highlighted a number of key challenges and areas advisers should be mindful of, with suitability and risk mapping raised as particular areas for concern.

Establish processes and clearly define roles at the outset

Every discretionary investment manager will have their own processes and approach to risk. They will also have their own responsibilities, which will depend on the contractual relationship between their firm, the adviser and client.

Unless clear lines are established as to how the relationship will operate at the outset, challenges can ensue. Time should be spent during the initial due diligence phase – and regularly reviewed as part of an ongoing process – to understand each discretionary manager’s approach to risk and where the responsibility for suitability will sit.

Will the discretionary manager take responsibility for suitability or will it fall on you, the adviser? In the case of bespoke portfolios it will often fall to the discretionary manager, given they are managing to a specific mandate for the client. However, that’s not always the case and it will depend on the specific agreements in place.

For Managed Portfolio Services the lines of responsibility will differ depending on the preferences of the discretionary manager and adviser (we know many discretionary managers who provide the option for advisers to choose). In any case, if the adviser is responsible, then strong lines of communication need to be established to ensure that any changes to the client’s circumstances or needs are articulated to the discretionary manager, and acted upon, within a reasonable time frame.

Risk mapping portfolios – there’s no perfect solution

An area covered at length during the discussion was the risk mapping of portfolios. Unfortunately, the alignment between commonly used risk profiling tools and discretionary portfolios can be arbitrary. Often advisers end up force-fitting discretionary portfolios to fit the outputs of the tools they prefer – a massive risk for their business.

Rory Percival (ex FCA) also speaking at our event warned that a lot of risk tools available in the market today are ‘not fit for purpose’. He intends to address this in a paper due out next year (we understand his paper will distill the different tools available, how they work and whether they are up to date).

Work together to evaluate and manage risk

To ensure the best client outcomes a sensible approach is to work closely with your chosen discretionary investment partners to understand how they manage risk, where their portfolios sit on the risk spectrum and in particular, how they integrate with risk profiling tools.

All dimensions of risk need to be captured and evaluated: the client’s risk profile, their capacity for loss and ‘risk requirement’ (i.e. how much risk do they need to take in order to generate a return that will enable them to achieve their goals. Not enough risk will leave them ‘at risk’ of falling short). This is where cash flow modelling tools come into play. How then to match these metrics to the discretionary portfolios on offer?

This one particular area requires a fair amount of work and shouldn’t be overlooked. Until we have Rory’s paper next year (Rory, if you’re reading this the pressure is on!) care should be taken to ensure you have absolute clarity on how risk is being measured and what the client experience is likely to be.