In the post-RDR world, advisory business models are evolving and continual improvements are being made to their financial planning processes.
Increasingly, Square Mile observes that many advisers have designed centralised investment propositions centered around third-party strategic asset allocation tools.
The FCA continues to stress that advisers have a responsibility to understand how such tools work. We have met with several advisers who do not seem to be as fully conversant with these tools as they should be. Worryingly, this could lead to unsuitable advice and potentially bad outcomes for investors.
Advisers will be familiar with the concept of the non-linear pay off between investment risk and reward. Initially, adopting a little more risk can materially enhance returns for a portfolio, however, as more risk is adopted the incremental return benefits become less.
Several risk tools, for example Distribution Technology, are calibrated so that risk bands are determined by equal amounts of volatility. The non-linear relationship between risk and return ensures that the incremental expected return benefit of moving from risk class 2 to 3 is normally greater than say moving from 8 to 9 (see chart 1). The curvature of this line depends upon the risk and return assumptions for each asset class within the model.
Other risk systems, such as EValue, do not apportion risk ratings in equal volatility bands. EValue widens the volatility bands as you move up the risk scale and this results in a more linear progression in the expected return profile.
Chart 2 demonstrates this in a stylised manner and note the significant jump in the volatility range moving from risk grade 8 to 9, relative to moving from 2 to 3. The regulatory required fund SRRI number is also calibrated in similar fashion.
Perils of mismatches
Square Mile does not argue that one approach is right and the other is wrong. However, this subtle difference in approach taken by different models raises some interesting questions. How are clients to be appropriately placed into the correct risk band?
Advisers must use care to ensure that the output from the attitude to risk tool is correctly calibrated with the risk grading scale used within the strategic asset allocation model. This is not so much of a worry when advisers stick with tools from a single suite such as DT’s Dynamic Planner or EValue’s Advisa Centa. But it is a concern when advisers use a more modular approach.
It is very clear that advisers need to take great care in calibrating risk bands across their planning process
A more modular approach allows advisers to cherry-pick what they see as the best ATR tool, the best SAA modelling for example, within their planning process. However, it is very clear that advisers need to take great care in calibrating risk bands across their planning process. Mismatches can easily be overlooked and only become apparent once clients suffer unexpected losses.
More worryingly, we have found some advisers who have taken the recommended asset allocation positions from different modelling to arrive at an average allocation. The various approaches to risk banding by the different systems makes them incompatible. The idea that by taking an average somehow presents a more robust output is just nonsense given the fundamental differences in the way that the risk bands are calibrated.
As it happens, DT’s model currently produces a relatively linear pay off between risk and return (we suspect this is due to the strong return potential of emerging market equities), so the potential issue is not as great as it could be.
However, advisers taking a mishmash of output from multiple tools to build their strategic allocation could easily end up with problems.
Financial planning tools such as ATR systems and SAA tools are complex systems. Advisers should be aware of any limitations and weaknesses in the tools that they use.
Correctly employed, such tools can be used to produce a robust financial planning process fitted around a centralised investment proposition.
Jason Broomer is head of investment at Square Mile Investment Consulting & Research