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How to demonstrate due diligence on risk rated funds

I was asked recently to give a presentation at an industry gathering of IFAs on the subject of, “How should advisers conduct due diligence on multi-asset funds?”

This raises two main questions, first, what should IFAs be looking for when conducting due diligence and second, how should IFAs seek to assess suitability? Ultimately, you cannot consider a product without considering the aims and objectives, capacity for loss and risk profile of the client.

Due diligence can be simple or difficult, quick and easy or detailed and painstaking. The level of due diligence that an IFA carries out is ultimately down to them and their investment proposition/business model and there is not, as far as I am aware, a definitive checklist available to do this.

Getting a due diligence process right is important, as IFAs want to give clients good advice and do not want to experience a Homer Simpson-style realisation that the investment they have recommended has gone wrong.

There is also the incentive that claims management companies are looking at the advice given by IFAs and that, quite rightly, the regulator expects an IFA to carry out appropriate due diligence.

There has been various advice/guidance issued by the regulator which I have noted and am happy to share with you.

Speech by Rory Percival, FCA technical specialist, 22 October 2013:

I have become a fan of Percival as a result of this speech which, using the terminology of the regulator, was clear, fair and in no way misleading.

Percival explained that the regulator is fairly loose on how advisers should go about their advice processes, as long as outcomes are in the client’s best interests.

He also said: “Due diligence is an area of concern for the regulator because it is an area that underpins a lot of problems of crystallised risk that we have seen in the past. It is an area that we strongly recommend that firms think about.

“Over the coming months and into next year the subject of due diligence will continue to be on the agenda and my hope is the industry generally and participants within the industry will continue to talk about what good due diligence looks like and to move everybody forward in that respect.”

Percival said the FCA found it easy to pick examples, such as Keydata and Arch Cru, where firms were not undertaking adequate due diligence around the investments that they were recommending.

He specifically highlighted the fact that relying on marketing material is “not acting professionally and in the interest of the client”.

Relying on facts is allowed, however.

“You can rely on what other firms tell you if it’s factual information. What you can’t take at face value is opinion,” he said.

To apply this to investments, this means advisers can accept factual elements, such as investment holdings, at face value but not an investment company’s own risk rating.

“If a company says this is a low risk fund, that is opinion,” he said.

FSA asessing suitability paper – January 2011

The full title of this FSA consultation paper was “Assessing suitability: Establishing the risk a customer is willing and able to make and making a sensible investment selection.”

The FSA, as it was then, highlighted the potential for poor customer outcomes aligned to a number of key risks and I think it is worthwhile highlighting a few of these which I believe are important in terms of due diligence. These are:

  • Relying solely on volatility as a proxy for risk.
  • Firms not recognising the importance of considering diversification.
  • Firms not understanding the nature and risks of the products or assets selected for customers.

 In the report the FSA said: “Some firms rely on the output from third-party tools without fully understanding the limitations or the circumstances under which the tool should or should not be used. Firms should be particularly mindful of the risks of an approach using different elements of different tools in a single suitability assessment as this could lead to tools being used differently to the way intended. For example, the definition of ‘cautious’ generated by a risk-profiling tool could be different to the risk of a ‘cautious’ portfolio generated by an asset-allocation tool if they are using different underlying assumptions.

“Firms need to take reasonable steps to ensure that the tool is fit for purpose, taking into account their business model and suitability assessment process.”

In addition to volatility, the FSA highlighted other measures of risk to be taken into account (where relevant). These are, the underlying assets in the fund, the risks related to the structure of the product, liquidity risk, the risk arising from lack of diversification, specific risks associated with the features of a particular product; and counterparty risk.

The regulator’s concern is that where volatility is used as a proxy for risk ignoring other risks in an investment selection can result in the inclusion of complex assets that are not suitable given the risk a customer is willing to take and their capacity for loss.

The regulator gave as an example, assets which are not traded daily on mainstream markets and can be difficult to value or appear to have low volatility, but are not low risk i.e. perhaps private equity or traded life policies?

Going back to Percival’s speech from 2 October, responding to a delegate query on how to evidence use of outsourcing solutions in any form, Percival said that although the regulator does not like to be prescriptive on how advisers do this there are four main steps:

1)          Think: Is the solution right for the client?

2)          Make sure the solution is robust.

3)          Write down the decision making process.

4)          Check it works and monitor it.

One minute guide to due diligence – 30 May 2013

From this document I highlight the following:

  • Have clear definitions of attitude to risk so the customer is clear about what each means and how they relate to them.
  • Ensure an adequate assessment of the customers risk profile has been undertaken and the product recommended matches this.
  • Don’t recommend products that you don’t fully understand.
  • Present all information in a way that is clear, fair and not misleading.
  • Consider the amount of knowledge your client has, particularly regarding “sophisticated” products.
  • Have you presented the potential downsides to your customer, as well as the potential benefits in a balanced manner?
  • Ensure the customer is clear why the product is right for them and why it meets their objectives.

So, how should advisers conduct due diligence on multi asset funds (or any fund for that matter)?

Being as clear and simple as possible, advisers should have a clear process and structure to researching products which should be:

  •  Clearly Evidenced
  • Recorded
  • Kept Up to Date
  • Advisers should not rely on risk ratings alone
  • Any risk rating is a constituent element of an investment research process but it is by no means the be all and end all
  • Advisers should be aware of how funds are managed – passive/active, asset classes, rebalancing frequencies, performance history, liquidity, counterparty risk
  • Do not recommend anything you do not fully understand

I cannot guarantee that doing all of the above will mean that the regulator will be happy but my expectation is that it will not be upset?

Andy Gadd is head of research at Lighthouse Group

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