Look beyond portfolio labels

From conservative to adventurous, labels can mean very different things to different people. With this in mind, it is vital advisers look beyond them and get to grips with a DFM’s true objectives. Gillian Hepburn, co-founder of Discus, tackles the issue...

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What does “adventurous” mean to you? I am known to be a bit of a coward, so living in Edinburgh, my definition is climbing the 288 steps in the Scott Monument and daring to look over the edge. My colleague, however, would want to scale it from the outside, then abseil back down. Adventurous is a subjective word.

The FCA has quite rightly raised concerns about the naming of model portfolios for that very reason. Its platform market study interim report highlighted the following:

“Risks and returns of model portfolios with similar risk labels are unclear. Consumers or their advisers looking for a particular risk level portfolio may have the wrong idea about the risk-return levels they face”.

This comment raises three key points:

  • The risk labels may be unclear
  • There is an assumption there is a good understanding of the level of risk the client is prepared to take
  • There is a robust process of aligning one with the other 

 Let’s look at these in a little more detail.

 1. Risk labels are unclear

A quick check of some of the key players in the portfolio market (typically discretionary fund managers) identifies a range of names, including cautious, cautious conservative, balanced, defensive, medium risk, high risk, adventurous and moderately adventurous.

 These labels are all subjective. What does “cautious conservative” mean to a client?      

 The provision of model portfolios on platforms has increased exponentially over the last few years, so the labelling or mislabelling of models is a growing problem - leading to an even bigger problem of the potential for inappropriate client outcomes.

 2. Understanding client risk levels

 Back in 2011, the FCA’s “Assessing suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection” identified some risk tools had a number of flaws and that many advisers failed to take account of clients’ capacity for loss.

 The concerns indicated by the regulator about the risk tools themselves have largely been addressed. However, research conducted this year by FE found 91 per cent of advisers use an attitude to risk questionnaire as a starting point for a discussion with their client about risk appetite, yet 59 per cent then assess the client capacity for loss based on a conversation. How this process translates into a final risk mandate is unclear.

 While the client may be able to take a certain level of risk according to the output of a tool, the suitability of the investment also should be based on their financial needs, objectives and circumstances and how they behave. Thanks to Mifid II, the receipt of a 10 per cent depreciation notice is a real indication of client behaviour.

 Behavioural profiler Be-IQ founder Neil Bage believes advisers need to take a broader behavioural view of a client. For example, some clients receiving the depreciation notices are realising their perceived risk profile is somewhat different from the behavioural reality the notice drives.

 Bage suggests the Mifid II 10 per cent rule can awaken a sleeping giant. For some people, receiving the depreciation notice is the right nudge. However, for many, they do not need to know, especially if they are following a long-term financial plan. Understanding how people may react to this is part of the Be-IQ approach; identifying these disconnects at the outset.

 3. Alignment of risk to investments

In addition to the challenges of the risk mandate and subjectivity of portfolio labels, the final hurdle for advisers is to map their risk assessment process to the outcomes delivered by the model portfolio solutions.

 The survey conducted by FE indicated there was “a disconnect between many advisers’ client risk assessment process and the way in which they mapped this to a suitable investment solution”. This is hardly surprising given portfolios are built on a set of assumptions as to “the middle” and many solutions comprise five or six portfolios covering a range of risk profiles.   

 Seventy-three per cent of advisers also admitted to combining clients’ assets across more than one model portfolio in order to achieve diversification. I am not sure what this gains other than diversification of the portfolio manager. Any blending of portfolios should consider asset allocation, underlying investments, cost and volatility.

 So, what advice, if any, can be given to advisers seeing as less than half of them (48 per cent) have reviewed the underlying mapping methodology?

  • Labels are a starting point only. DFMs will provide mapping information but the adviser is still responsible for ensuring the portfolio meets the client objectives.
  • Review all the DFM documentation, particularly the objectives for each portfolio and how the portfolio is constructed.
  • If the portfolios map to a range of outcomes, what is this range and how does this relate to the adviser process?
  • How is volatility in the portfolio managed?
  • How is the portfolio managed to ensure it remains aligned to the risk profile?
  • How is the portfolio diversified?
  • What is the level of liquidity?

 In conclusion, do not just get the mapping process but meet the DFM, explain your risk assessment process, ignore the labels and look at the outcomes the portfolios are designed to achieve. 

Gillian Hepburn is co-founder of Discus

Gillian Hepburn is now Intermediary Solutions Director at Schroders

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