Money Marketing takes a look at the role advisers should play to help DFMs build suitable discretionary portfolios
With an ever-greater regulatory focus on taking the right risk for the right client, eyes are turning to how discretionary fund managers actually turn an adviser’s fact-find into an investment portfolio.
Last year, the FCA looked at naming conventions of model portfolios and ruled that terms such as “cautious”, “balanced” and “adventurous” often refer to significantly different risk levels across different providers.
Risk-profiling tools that can lump supposedly like-minded clients together have faced continued scrutiny over whether or not they are fit for purpose, but what about in-house equivalents at DFMs themselves and their use in discretionary portfolios?
Compliance pressure has pushed advisers to more digital solutions for risk profiling which also allow the face-to-face time vital to sustain good client relationships.
The motivation to outsource to DFMs since the RDR is a similar one, but the choice is as contentious as it is popular.
How to map the results of a client risk profile to suitable investments is still a grey area with no one-size-fits-all approach for DFMs to take.
However, they do not always line up with the regulator’s requirement to be scientifically robust.
He says: “There is no clear way to link the output from a questionnaire on an investor’s attitude to risk and capacity, and the resulting investment products. To achieve this, there would need to be some form of common statistic between the two.
“Given this doesn’t exist, a link has to be established that looks to describe the investment journey.”
Money Marketing spoke with experts on what mechanisms are best for mapping clients’ risk profiles to investment portfolios.
The adviser’s role
Correctly ascertaining a client’s tolerance for risk is a clear first step to building a discretionary portfolio.
Consultant Rory Percival says: “Before anyone even gets to the risk-mapping that happens before the portfolio construction, there’s the client risk profile and there’s quite a mix out there of how that risk profiling of a client is done.”
In order for DFMs’ risk mapping to be accurate, advisers need to ensure similar processes are being used across the board for clients.
Financial Technology Research Centre director Ian McKenna says: “It is important advisers use the same profiling tool for all customers because they aren’t interoperable.
“A DFM cannot be expected to pick up between tools like that and then make an accurate summation when risk mapping.”
Advisers should communicate clearly with DFMs on what method they choose for risk-profiling, Percival adds. “Advisers should use a proven, scientifically-best psychometric risk-profiling tool.
“They don’t have the expertise to create a psychometric test in-house, but non-psychometric tests can run the risk of measuring the client’s risk perception rather than their risk tolerance.
Jeannie Boyle, managing director, EQ Investors
We have an in-house risk-profiling solution that we have built specifically with our clients’ needs in mind. Using that means we can make sure things match up for them. It also allows us to have full control over presentation and output. An in-house system hasn’t always been the method we use and we have called in external help in the past, but this solution works best for our clients. There are some great independent risk-profiling tools out there, but we have the capacity to keep that in house, so we do.
“Risk perception is a volatile measure and risk perceptions are very susceptible to be short-term like bad news and isn’t a true representation of their underlying risk tolerance.”
Speaking at a live debate hosted by Money Marketing last week, Charles Stanley investment manager Nicola Loudon said advisers must trust DFMs, but be prepared to work with them on finding a link between a client’s risk profile and the suggested risk-mapping.
She says: “Every party wants to do their best by the end client and that requires bespoke communication on what people want or need and the level of risk they can handle.
“The more information the DFM gets from the adviser, the easier our processes are.
“It is 100 per cent vital that the DFM is responsible for their own risk-mapping because the process needs to be seamless.”
A Rathbones and CoreData report from November says many advisers who choose not to use DFMs do so because they fear justifying the external costs to clients.
However, advisers would be wise to consider the risks of not outsourcing when thinking about getting investment risk right, Percival says.
“There’s a risk if you do it yourself that you’re actually measuring the wrong thing and risk-mapping is such a problem area.
“Most advisers will use risk bands based on volatility bandings but volatility is not a perfect measure of risk.”
The technology terrain
The FCA has suggested that advisers should have a firm understanding of any technology that is used by DFMs after they outsource investment control to them.
McKenna says: “The adviser is responsible and needs to decide the process of the risk-mapping too, with the explicit regulatory requirement that if you are using a piece of technology, whatever it is, you need to understand what the methodology is so you can back-test it.”
Any lack of communication between an adviser and a DFM could also end up attracting unwanted attention.
He adds: “The adviser has to understand the risk-profiling then risk-mapping process. Using different tools with different DFMs could lead to regulatory inconsistency within an advisers’ business that could concern the FCA.”
Brewin Dolphin, one of the best-known DFMs in the market, relies solely on advisers’ own risk-profiling, and does not do initial assessments itself.
Brewin does not generally have direct communication with advisers’ clients and says it determines how the risk is mapped to investment together with the adviser’s fact-find.
A spokeswoman says: “We work closely with advisers to agree on the correct portfolios for their clients based on suitability criteria. We find this approach very constructive and supportive for the adviser and client.”
Copia Capital Management portfolio manager Hoshang Daroga says DFMs should consider looking beyond long-run expected risks when risk-mapping.
He says: “This is helpful for a broad strategic allocation but can have little relevance in the short-run and can be some way off from realised volatility. A granular approach that also looks at maximum drawdown and value for risk is important.
“Risk-profiling dominates the investment process but DFMs can challenge the homogeneity it creates. Advisers should be focused on client-specific outcomes and custom portfolios.”
Dealing with decumulation
The unavoidable reality of longer life expectancy has radically changed how advisers manage clients in decumulation.
Platforum associate research director Richard Bradley says: “DFMs feel that they are well placed to help advisers manage their client assets over lengthening decumulation timelines and they feel they can bring a greater rigour to managing safe withdrawal rates, income and risk in portfolios.”
Many advisers favour a “bucketing” approach for clients in decumulation – combining low-risk assets for the short term with higher-risk assets for the long term.
In addition to larger providers, smaller DFMs like Parmenion and Copia Capital Management already provide ranges of drawdown-specific portfolios clients can be placed into dependent on how they are risk-mapped.
Copia chief investment officer Henry Cobbe says personalised risk-mapping from the DFMs’ side is crucial for post-retirees and should always involve the adviser for accuracy.
He says: “Decumulation clients’ objectives, needs and characteristics are very different from those in accumulation; time horizon is key, so risk-profiling without that is meaningless.
Why suitability pivots around how much a client will risk
Most clients don’t have sufficient funds to achieve long-term objectives without seeking higher returns which entail taking investment risk. The suitability of any financial plan therefore pivots around the risk the client is willing and able to take.
The challenge for advisers is that each asset manager uses their own definition of risk and each will have their own objectives. The work the FCA did last summer on platform portfolios clearly demonstrated that one manager’s “balanced” is another’s “adventurous”.
The role of the independent investment process is to provide a framework that helps ensure that the adviser and client understand the risk that an investment represents. It is also to translate the client’s risk profile into a mandate asset managers can reference or target. This requires taking a forward-looking view on the risk-return characteristics of different asset classes and underlying investments – independent of the asset manager or product provider.
Advisers can also compare investment performance on an “apples for apples” basis – i.e. what performance is being delivered for a given level of risk after charges? This is both the definition of value for money used by the FCA in its Asset Management Market Study and what it is seeking to achieve with the benchmarks policy statement PS19/4 this month.
There are an unlimited number of strategies available to deliver a risk return mandate: passive, active, discretionary, ethical, value, growth. What’s suitable depends on the client’s circumstances and preferences.
The role of the adviser in helping clients understand their own objectives and the risk they need to take to achieve them, while identifying the most suitable investment characteristics, will be around for a long time yet.
Ben Goss is chief executive of Dynamic Planner