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Ben Goss: Three misconceptions around risk profiling

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Much has been written on the topic of risk profiling recently. As a company we pioneered the use of questionnaires and model asset allocations over 10 years ago and never has the discussion been so energised as it is currently.  

Eleven years ago, when we founded Distribution Technology, over 80 per cent of advisers determined a client’s attitude to risk through ‘a general discussion’, rather than using a tool of any description according to NMG Consulting.

Today that ratio has swung the other way with NMG reporting that 70 per cent use a tool and only 30 per cent relying on the general discussion.

In a recent Money Marketing article, the FCA’s Rory Percival said that while the number of firms assessing capacity for loss has improved, the regulator does not believe the issues with assessing suitability have gone away.

He also said some firms are failing to provide clear and adequate client explanations about different risk profiles, and are also not being clear enough about the risk of making a loss.  Clearly there is also a balance to be struck, advisers also need efficient solutions, ones which don’t drive “over compliance”, as Rory pointed out at our annual conference last month.

So quite rightly the debate has moved on, from whether using a professionally and scientifically developed and objective tool is a good or a bad thing to how well is that tool understood and then used.

Like all tools; compasses, satnavs, in-car computers, risk profiling systems have their strengths and limitations.   

Understanding risk profiling and asset models

There are a number of common misconceptions around risk profiling and asset modelling.

The three most commonly quoted are:

1 Using a risk questionnaire on its own is good enough  

There are clearly two sides to risk profiling; establishing the investor’s risk profile and understanding the potential investment’s risk. 

These two things done with the same risk definitions and boundaries, granular asset class assumptions and data definitions ought to mean that your tool or process is reliably translating and communicating the nature of risk from client to investment manager via the adviser on a consistent and granular basis.

With a professionally constructed and properly tested model you should be able to articulate the range of likely outcomes to clients in a transparent manner where there is a shared language of risk and the client fully understands the potential likelihood and nature of making a loss.

2 Asset models and fund risk profiling is backward looking relying solely on historical volatility. While this is true of the synthetic risk reward indicators required in KIIDs it is not true of a good asset model or fund risk profiling service. When looking at a fund one should first consider its current asset allocation exposure and that gives a view on likely potential strategic risks. We also look at the manager’s mandate and their ability to move into riskier asset classes as well as their track record of managing within a given risk profile. Estimates for volatility, correlation and future returns by asset class are all factored into any profile as well as looking at historical performance. Our capital market assumptions factor in long periods of history together with the latest market information on equity risk premium, credit default rates and interest rates for example. Estimates are tested on a quarterly basis and agreed by an investment committee.

3 “Risk profiling” is the same as “risk rating”.

This might sound like semantics but the difference is important. While research firms rate which funds they feel will perform best in a particular sector or peer group and have built their businesses around this, risk profiling assesses investments on their risk alone and should not attempt to rate a fund manager’s likely success or otherwise from a performance standpoint as there are many strategies managers can utilise to deliver their mandate.

What advisers and their clients want first and foremost is a clear risk-return mandate set for any fund or portfolio they invest in.

This approach has been successfully used to manage institutional pension funds for many decades.  The key thing is  to translate that mandate from the investor to the fund manager on a consistent basis; giving all parties an ‘apples for apples’ basis for discussing risk.

Using tools well

Data shows, advisers are not ‘slavishly’ following questionnaire outputs.

The client’s attitude to risk is of course only one dimension to an investment decision. Their existing investments, capacity to take on risk, time horizon, goals and objectives should all be factored into a personal investment strategy.

From a sample of over 50,000 cases last year we can see that while 80 per cent of the time advisers whose clients ATR score was risk level 3 out of 10 (low risk), agreed that they should invest in this profile, the percentage falls to 75 per cent at risk level 5 and 60 per cent at risk level 10.

It is clear advisers are, on balance, engaging with clients and helping them take less risk. In a minority of cases we can see that advisers are advising clients to take on more risk, perhaps if higher returns are desired and the client has the capacity and time horizon to do so.

We believe that so long as advisers are using tools and processes which have asset model integrity this should lead to better outcomes for all.

Ben Goss is chief executive at Distribution Technology 

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Comments

There are 3 comments at the moment, we would love to hear your opinion too.

  1. Samuel Lewis Mayes 20th May 2014 at 1:18 pm

    Good Article Ben.

    Risk Profiling tools are essential in my estimation.

    However, the danger is that the assumptions and outputs used by various risk models can give different risk ratings for the same client. This may affect recommendations and appropriateness when later reviewed.

    This is exactly what claims managment company’s are doing right now to generate leads and claims i.e. assessing a clients ATR with their own in-house ATR model and finding a higher risk product has been “mis-sold”.

    All input and assumptions will be regulated one day…

    Sam

  2. Thanks Sam, I think your point underlines why having a consistent basis for risk profiling; of clients and investments is so important. Asset model integrity across both on an ‘apples for apples basis is critical to ensure a suitable outcome. If that’s done properly, very difficult for someone to come along after the fact and claim your assessment wasn’t appropriate.

  3. Thanks Sam, I think your point underlines why having a consistent basis for risk profiling; of clients and investments is so important. Asset model integrity across both on an ‘apples for apples basis is critical to ensure a suitable outcome. If that’s done properly, very difficult for someone to come along after the fact and claim your assessment wasn’t appropriate.

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