Investors are being urged to check that their adviser’s definition of “risk” concurs with their own, amid concerns that some advisers are treating risk profiling as a “box-ticking” exercise instead of conducting proper research.
Risk profiling has become increasingly important as the financial regulator cracks down on unsuitable advice and investors seek greater certainty in the face of volatile markets since the financial crisis.
Riskier portfolios are not only more likely to suffer a big loss, they are also likely to be more volatile. Assessing the risk of different products offers investors and advisers the chance to control volatility.
A number of tools are now available to financial advisers that help them measure investment risk, including financial planning software and questionnaires that attempt to quantify a client’s attitude to risk.
Advisers say they also expect to see an increase in the range of “risk rated” or “risk targeted” funds, which use historic volatility data to either allocate a risk rating or make investment decisions according to an acceptable level of risk.
Recent research by Skandia Investment Group found that investors were increasingly looking at risk before even considering returns, but Adrian Lowcock at Hargreaves Lansdown said investors needed to remember that the risk in an investment can change over time.
“My concern is that these products are being launched in a large volume and then used to tick a box with clients to say they fit in risk profile three, or something similar,” he said. “Advisers will need to make sure they look underneath the bonnet and analyse what each fund does and how it performs.”
The financial regulator is also concerned that some advisers may be using third party tools to oversimplify a complex and highly subjective issue.
Since July, all investment funds in Europe have had to come with a simplified explanation document – the “key investor information document” or Kiid – which includes a risk rating based on historic volatility designed to make fund comparison easier.
However, research by the Association of British Insurers and the Investment Management Association in 2010 found that half of all UK funds would have the same risk rating under the new methodology.
Ahead of the shake up of financial product sales, the Financial Services Authority has been examining how advisers assess client suitability when making sales and has warned advisers not to base all of their decisions on the risk rating in the new documents.
In June the FSA wrote: “we have seen evidence of firms failing to challenge cases where automatically generated investment selections (for example, from model portfolios or asset-allocation tools) are unsuitable for individual customers.”
Clare Murphy-McGreevey, spokesperson at the FSA, said that the regulator had warned firms not to shoehorn clients into investments just because they appear to have the right rating.
“Advisers need to assess risk on an individual basis. The firm has to come up with the methodology, it cannot rely on fund group risk ratings,” she said.
Independent financial adviser Tim Cockerill, of Rowan Dartington, agreed that any risk profile questionnaire had to be the start of a discussion, not the end.
“My view is that we can’t take anyone else’s rating, whether that’s from a Kiid or a risk-rated fund,” he said. “The FSA doesn’t lay down hard and fast rules about how to measure client risk but it comes down to knowing your client – knowing their objectives, time horizon and investment experience.”
Rowan Dartington uses a system that grades investments between one and five, with one the lowest and five the riskiest. It then allocates a grade to clients and chooses a portfolio. At the lowest end, a portfolio would contain cash and lower risk corporate bonds. Equities, Cockerill said, would not be included unless a client had a risk rating of three or higher.
The firm has had conversations about the correct risk identity of certain assets and Cockerill acknowledges that traditional “low risk” investments may have lost some of their haven status. “ Gilt yields are low so there is now an investment return risk,” he said. “But at the same time we don’t believe the UK government will default and that coupons won’t be paid, so we still consider these low risk.”
Duncan Carter, director of Clearwater Financial Planning, has opted to eliminate the terms “low risk” and “high risk” altogether when discussing the issue with clients because they are “too arbitrary.”
“We think capacity for loss is more relevant than willingness to take risk,” he said. “Things have changed this year for advisers. We’ve been working on our risk profiling for more than five years. It’s never going to be perfect but we’re happy with it.”
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