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Heed the warnings

In my last article, I started to look at some of the ways in which IFAs can learn from the various regulatory reviews and legal judgments affecting financial services.

I considered first a series of recent judgments from the Financial Ombudsman Service which shed a great deal of light on the way in which single-premium investment bonds – in particular, high-income or precipice bonds – should or should not be marketed as regards the suggested level of risk they offer to investors.

I would now like to look at some other important FOS decisions affecting investments before moving on to a selection of mortgage endowment and pension cases.

First, a word of warning for the increasing number of advisers whose clients state a preference for ethical investment. A few months ago, the FOS reported on a complaint from a couple who had invested around £25,000 in an investment bond. After stating that they hoped to invest in ethical companies, the couple accepted a fund recommended by the adviser.

Several years later, however, they decided that the ethical investment advice had been inappropriate and complained to the adviser and then to the FOS.

The FOS upheld the complaint on the basis that, while the suggestion of the ethical fund was prompted by the clients, they had also demonstrated a low attitude to risk, which was not compatible with an ethical equity investment fund. Moreover, the clients stated that they had only suggested an ethical investment, not insisted on one.

The FOS report also stated that: “There was no evidence that the adviser had given the couple any warning about the risks involved…He should only have gone ahead and arranged the investment after he had set out the risks in writing and obtained written confirmation from the couple that they wished him to proceed.” We can probably assume this would be the FOS&#39s view in the case of all investment transactions and not just those involving ethical investments.

I am aware that an increasing number of firms are adopting a procedure where they not only give statements of risk warnings in writing but also obtain confirmation that clients understand and accept those risk warnings. However, the still significant number of firms which do not follow such a process should be warned by such judgments.

Next, a lesson to firms which might be slavishly transferring investors out of with-profits bonds in favour of unit trusts, for example. A recent FOS report quoted the case of a 64-year-old widow who, guided by her adviser, encashed a with-profits bond and invested the money in a unit trust. The widow said she accepted the advice for this switch partly as a result of her adviser claiming that the unit trust offered superior tax advantages but also partly because of her belief that unit trusts did not involve any degree of risk.

The FOS upheld the complaint not because of any preference for or against with-profits bonds but because the adviser&#39s documentation relating to the meeting and the advice given was insufficient to lead the FOS to refute what the client claimed. The fact-find, in particular, was cited as being particularly weak in confirming that the adviser had made a full assessment of the client&#39s circumstances.

Once again, this illustrates the FOS&#39s tendency to believe the client&#39s version of events where the adviser cannot provide adequate documentation that the client accepts the risks highlighted by the adviser.

Now let us move on to a warning in a recent FOS case about recommendations for overseas equity funds. A couple had approached an IFA following advice from a friend that their UK equity funds would probably perform better if switched to European equity funds. The adviser recommended switching to an Isa invested in a European fund. However, the couple lost more money in the European fund than they would have done in their UK fund.

As in the cases I have already outlined, the FOS upheld the complaint mainly because of the lack of an appropriate risk warning given by the adviser.

In fairness to the firm, the adviser had confirmed that the clients were medium-risk investors who had, moreover, quite substantial experience of equity investing, as witnessed by their previous UK equity fund holding within an Isa. The adviser had also furnished the investors with a key features document and other product literature. What more could the adviser have done and what did the FOS conclude he had done wrong?

Fundamentally, the FOS decided that the European fund presented a higher degree of risk than the UK equity fund because of the impact of currency fluctuations. We might conclude that this line of reasoning could be applied by the FOS in similar cases where any geographical area of overseas equities is held within a fund – probably even within a managed fund.

Without a doubt, the currency risk within overseas funds (mitigated by those which hedge against currency risk) is widely understood by most advisers but I would pose the question as to how many firms routinely explain this risk to clients and obtain confirmation of their understanding and acceptance of this higher degree of risk?

Some of us routinely use overseas equity funds within a structured portfolio to reduce the overall level of client risk. In particular, where this diversification is used to reduce risk for relatively unsophisticated clients, I would suggest that an attempt to explain currency risk might be futile as well as inappropriate or irrelevant as overall portfolio risk should be reduced.

In the latter case, the FOS determined that the European fund was higher risk not only because of currency fluctuations but also because it invested quite heavily in technology shares, which are generally accepted to represent a higher level of volatility than most other equity sectors. From this line of reasoning, advisers should perhaps be just as careful when recommending funds which invest heavily in small company shares or funds which concentrate investment in a small number of share holdings.

In conclusion, advisers should remain fully aware of pointers within funds which could indicate a higher-than-average level of risk and ensure this is properly brought to the attention of investors.

I fully accept that the discussion within this article and the guidance given by recent FOS decisions might already be entirely obvious to advisers but I believe that one or more of the issues raised by these reported cases could prove valuable talking points for many firms whose advice-giving procedures are not as robust as the FOS clearly believes they should be.

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