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Aligning client expectations with their attitude to risk

Many investors remember only too well the stock market melt down of 2008 and the subsequent low growth environment that prevailed for years after that.

With many investors remembering the pain of burnt fingers and the misery of the low return environment that followed, it is unsurprising that increasing numbers of investors are seeking capital preservation strategies, particularly those that offer the promise of protecting investors from loss and providing relatively attractive returns – for example, consistent returns well in excess of cash.

The motivation of an individual to invest is driven by two uncomfortable human emotions, fear and greed. That is, the fear of not having enough money to fulfil our basic and esoteric needs and greed, the excessive desire to acquire or possess more than one needs.

Underneath these basic motivations, each investor will have a view on how much risk they are prepared to take, usually based on their capacity for loss and hopefully with consideration of the length of time over which they wish to invest.

The time horizon of an investment is vital when considering the level of risk within a portfolio – the longer the period available the less, in theory, short term drawdown and gains matter. A longer term view to volatility can be taken. Taking the long view gives you the time to absorb the volatility and participate fully in the good times.

Capital preservation strategies that promise attractive returns surely fly in the face of the risk-return principle, i.e. the principle that potential return rises with an increase in the level of risk taken.

Low levels of uncertainty (low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are associated with high potential returns. If you believe the risk-return trade off principle, invested money can deliver higher profits only if it is subject to the possibility of being lost. The question is – do investors seeking capital preservation strategies understand the opportunity cost they are accepting in their desire to minimise short term losses?

Some would argue that there are successful total return models that deliver protection against market losses and consistent high returns, that set out to preserve capital in all market conditions whilst delivering a stable investment return well ahead of cash.

As the diagram below shows, hedge funds (blue) potentially give a smoother pattern of longer term return that the more volatile long-only World index (red).

 HEDGE FUNDS – EQUITIES VS. FUND OF HEDGE

Quilter graph-July 2013

However, a high profile absolute return fund recently recorded discrete 12 month performance returns of 0.9 per cent and 2.04 per cent in 2011 and 2012 respectively. Even in a low interest rate environment these returns do not compare favourable with 1 year saving rates currently available from UBL UK and Tesco or 2.25 per cent and 2 per cent.

So what has happened? In this particular case, the Oeic’s investment performance was held back by protective investments in the US dollars, the cost of buying put options and lack lustre performance of gold mining shares.

Quite simply conditions in 2012 did not require protection and as a result gains delivered to investors were out of line with the aims of the Oeic. The opportunity cost of this type of investment strategy is that in accepting lower volatility in the short term you are also accepting a smoothing of the upside. It is not that this is wrong, it is just that it is not the panacea to the intrinsic relationship between risk and reward that some hoped it would be.

Just as Gordon Brown over-promised in October 2008 that we would “….never return to the old boom and bust”, we are yet to see an investment model that does not ultimately see a positive correlation between the level of risk an investor is prepared to take and the potential reward. Too much focus on minimising the downside does have an impact on potential returns.

For financial advisers this can mean delivering some ‘tough love’ to clients. Advisers have a duty to ensure the suitability of their recommendations at inception and throughout the lifetime of that relationship. According to the regulator advisers must consider:

• client objectives and time horizon
• the level of risk that your client has the capacity and desire to bear
• and ensure that your client understands the relationship between downside risk and potential returns.

The adviser will need to determine whether there is any discrepancy between what the client has interpreted from misleading sales literature and what they actually want. Such discrepancies should be discussed with the client, as the most suitable advice may not be quite what they initially had in mind, once they have been provided with a balanced view.

It can be argued that it is not the short-term failure of a particular investment strategy that damages client relationships but the mis-management of client expectations, poor communication and a lack of personal accountability that leads to client dissatisfaction. Effective, timely and appropriate communication is fundamental to long-term relationships.

Investment managers cannot guarantee returns but they can build and manage portfolios in line with individually agreed investment objectives, risk tolerances and factoring in any other important nuances such as shares held for sentimental reasons rather than objectives ones.

An investment manager allows advisers to outsource their investment compliance risk while alleviating the huge time-consuming burden of fund research, asset allocation and day-to-day management of the investment portfolio.

This is especially relevant post-RDR as the regulator is looking for more rigour in the advice process. Due diligence and the assessment of independent research from bodies such as Defaqto are crucial in making this selection. The adviser can then spend their time focussing on their clients and business instead.

Financial advisers should look to an investment manager who develops their brief through an understanding of the client’s objectives, attitude to risk and other preferences. For example, if capital preservation is important, time should be taken to explore what this means and ensure the right balance between restricting portfolio drawdown and delivery of growth or income over the longer term.

The investment manager remains accountable for investment returns and should maintain a regular dialogue with the adviser and their clients as agreed at inception.

This service should be backed up with clear, regular portfolio valuation reports and commentary so that the adviser and their client are informed at every step along the journey. The aim is not to offer promises that are not sustainable but to provide advisers and their clients with suitable investment solutions backed by personal service and accountability.

Glenn Hawksbee is head of sales at Quilter Cheviot

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