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Investors exposed to risk-profiling ‘ticking time bomb’

Investors and advisers are exposing themselves to a ‘ticking time bomb’ by using risk-profiling tools, The Platforum has warned.

The investment and distribution consultancy says some firms are overly reliant on risk-profiling software and argues some tools are biased toward risk tolerance over capacity for risk.

In May, the FCA urged firms to provide transparent explanations for different risk profiles and highlight clearly the risk of making a loss. It prompted Distribution Technology to respond in a column for Money Marketing

In 2011, the regulator found that 9 of 11 tools reviewed had problems which could result in “flawed outputs”.

In its Stickman fund distribution report, published today, The Platforum says: “We have seen advisers developing or buying in risk-profiling questionnaires that are not fit for purpose. Some questionnaires are wholly focused on testing tolerance of risk and ignoring capacity for risk.

“The FCA has taken issue with the quality of some tools on a number of occasions, as well as advisers’ over-reliance on tools in lieu of having proper and explanatory conversations with clients. There are grave concerns over suitability if the logic of the tool is flawed.”

It also highlights the possibility that layering in multiple different risk-profile tools through the investment chain creates mis-matches.

The report says: “If an adviser or discretionary manager is mapping a client’s risk score to a multi-manager fund from one provider plus a model portfolio from another it can be a risky business.

“To achieve the right mapping, there needs to be very
 good visibility on how the profiling questionnaire works as well as how the end solutions work – both often closely-guarded secrets for commercial reasons.

“Consequently, assumptions get built into 
the mapping process. This could well be a ticking time bomb for investor outcomes.”

It adds that during research for the report some multi-manager firms expressed doubts about the long-term viability of risk-ratings over risk-targeting.

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Comments

There are 16 comments at the moment, we would love to hear your opinion too.

  1. If 9 out of 11 risk profiling tools are ‘known’ to be flawed, rather than let the time-bomb tick, why doesn’t the regulator just do the decent thing and tell the world which two are in perfect working order so the problem is sorted once and for all – now!

  2. Surely it would help all advisers and advisory businesses if the FCA had actually published which nine risk profiling tools they deemed unsuitable and the rationale behind it. How can they allow these tools to be made available to advisrs knowing they had issues which could result in “Flawed outputs”. Will they take any responsibility for potentially unsuitable advice as a result of them not making this information available? Not on your nelly!!

  3. The FCA could tell us which ones are good and which ones are not so good. Isn’t that just logic?
    Talk about making things hard. The FCA are experts at it.

  4. Rather than risk being sued for exposing the nine potentially unsuitable risk profiling tools, why don’t the FCA produce a shorter list of the two risk profiling tools that they deem to be acceptable, and reasons why they are suitable? Other than that I agree with the other commenters before me.

  5. @Brian – rather than endorse the 2 they like, why don’t they just do their normal and list the good practice, which would actually be the tools they like and then it gives the other 9 a chance to become like the 2 without being slagged off. By the time advisers work out which the two the FCA like, the others could have upped their game.

  6. Maybe by revealing the two good ones they would breach competition rules by effectively promoting private company tools to the industry?

    @ Truthseeker – Risk profiling tools do not give advice, they are merely tools.

  7. Unfortunately, risk profiling is an extremely limited and even inappropriate tool to use for investment advice. The FCA Handbook states that advisers must establish suitability rather than mere attitude to risk. Speaking as someone who provides a multi-dimensional suitability assessment tool, I’d welcome the opprtunity for it to be assessed by the FCA and have best practice defined!

  8. Personally I think the FCA doing like risk profiling tools full stop !!!

    The conversations I have had with the FCA over this, I get the feeling they what the subject of risk and capacity for loss, debated via a conversation with the client and recorded via the suitability report as a true account, they don’t say don’t use tools (the usual non committal you get) but they want to see you have asked the right questions (that’s down to the adviser and their own skill set) and be confident of your own / and your clients gut feeling and expectations

    I do use risk profile tools and used a number of them, however I am still amazed at the number of clients who fill them in to produce one set of results then after a detailed conversation we fix on another !!

    The providers of these (lets be honest) what you to buy into these for their own profit, by stating they are compliant and the FCA love it, and look how easy it is and all recorded for you !! Pppfftt most cases utter tosh !!

  9. Good points by DH and David Roberts. Risk Profiling Tools are much like Psychometric Tests, the results need discussing with the client to interpret them, and this should be just part of a much bigger conversation about risk and capacity for loss, and the need to take risk to achieve goals etc. Risk Profilers only assess clients tolerance to risk, not their capacity for loss or their need to expose their assets in order to achieve the desired outcomes. Hence the need to have the conversation so as to make sure that I and my client have as good an idea as possible as to what level of risk to take. However, some tools are better than others, and I would still like to know which ones the FCA considers to be more robust, and on what basis they have made this judgement. Not because they have any real insight into this, but more so that I know how my files are going to be judged in later years when they retrospectively annihilate them.

  10. Unfortunately, risk profiling is an extremely limited and even inappropriate tool to use for investment advice. The FCA Handbook states that advisers must establish suitability rather than mere attitude to risk. Speaking as someone who provides a multi-dimensional suitability assessment tool, I’d welcome the opprtunity for it to be assessed by the FCA and have best practice defined!

  11. @ Brain

    Your point of the FCA actually telling us, what are the ones to use, or in fact what is right, (they tell us plenty of what is wrong) is down to their complete lack of parenting !

    People often say we get the regulator we deserve, I say the regulator gets the industry it deserves !! children are led by example and defined parameters, no wonder the FCA have a brood of unruly, argumentative and un cooperative children.

    Baring this article in mind, if we are saying actually having a conversation is paramount and what the FCA are looking for ? why oh why do they not see the inherent problems with simplified and automated advice, you can-not (IMHO) offer risk, capacity for loss, then investment offering by automation or simplification.

    Here they say 90% of risk profile tools are crap, (you would presume a key part of an automated system), then turn round and say we are not being innovative enough and we are setting up (at great expense not doubt) a task force ? see my previous point about bad parenting.

    I could go on and on, bring in Jo Frost (I think that’s her name) I say; the parent (FCA) needs to stop and think and we need to follow and understand in defined parameters, no wonder we have no respect for the FCA, we are not allowed to do this, we are not allowed to do that, cross the line and get your arse smacked, an 8 foot rule book is not the answer; try telling your 8 year old to read the bible (other religious books are available) back to front and be tested on it in the morning and live by it for the rest of his/her life with no explanation or no reason why ? then why act surprised by the look on his face.

  12. MM - Mike Glenister 12th August 2014 at 11:22 am

    Some of you have asked why the FCA won’t name specific firms in relation to the story above.

    We put your questions to the FCA, and were told the regulator is prohibited from disclosing details about individual firms involved in thematic work. It cites the Financial Services and Markets Act, which prohibits it from disclosing ‘confidential information’. More details were included in a paper published last year. The relevant section is on pg 22:

    http://www.fsa.gov.uk/library/policy/dp/2013/13-01.shtml

    “There have been requests from consumer representatives that we should disclose the firm-specific
    results of thematic work. But the FCA is constrained by law from disclosing the
    firm-specific results of thematic work. Failure to name poorly performing firms can mean
    consumers are kept in the dark.”

    The relevant section of the FSMA is part 348 which can be found here:

    http://www.legislation.gov.uk/ukpga/2000/8/section/348

    And here is a link to the coverage we gave when the FCA published their paper on transparency:

    http://www.moneymarketing.co.uk/fca-will-not-name-and-shame-poor-firms-uncovered-by-thematic-reviews/1067064.article

  13. ATR, CFL and now CFR (who thought up that one?) can all be debated ad nauseam (and seemingly are) but the fundamental considerations are that:-

    1. Nobody considering investing money, however wealthy they may be, is blasé about whether or not they can afford to lose it.

    2. Better returns than cash or inflation cannot be achieved without accepting some measure of ebb and flow in paper valuations.

    3. Investments offering the prospect of better returns that cash or inflation must be approached only as a medium to long term proposition.

    4. Investment market-linked investments are NOT, as some people seem determined to believe (no matter what you try to tell them), simply turbo-charged versions of bank or building society accounts.

    5. It simply isn’t possible to nail down volatility to precise minima and maxima, only to gauge certain asset classes and fund and portfolio types as being less vulnerable to it [volatility] than others. This means managing client expectations.

    ATR questionnaires can only get you part of the way towards building a portfolio that’s right for each particular client. The tricky bit is recording your discussions around and beyond what the ATRQ asks in such a way as to minimise the risk of the client claiming at a later date that what you wrote down isn’t an accurate record of your conversations on the subject. It’s an art as much as a science and those who pretend otherwise are deluding themselves and trying to delude the rest of us.

  14. @Mike Glenister
    This isn’t about naming regulated firms, it’s about naming the profiling tools. Section 348 of FSMA is a very, very poor excuse. It clearly states that information cannot be disclosed “without the consent of… the person to whom it relates.”

    If the FCA asked the two firms who produced the ‘acceptable’ profiling tools whether they would be happy for the FCA to name them I suspect they might just give that consent…

  15. Interesting asymmetric argument from the FCA. Is it “firm-specific” when you’re talking about – unregulated – providers of tools that firms use, who presumably have a large enough client base among IFAs etc that the firm actually assessed would be effectively anonymous? Or should we infer that some of the nine ‘bad guys’ in the risk-profiling population are in-house developments?

    Or, should we infer that the tools themselves aren’t necessarily logically flawed, but rather its the way particular firms use them – which would be specific to those firms and therefore confidential information?

  16. @Adam
    To quote the FSA Suitability paper:

    “We reviewed 11 risk-profiling tools and were concerned to find that nine tools had weaknesses which could, in certain circumstances, lead to flawed outputs. Similar weaknesses are identifiable in non-tool approaches.”

    I think it’s clear from this that the problem was with the tool and not how it was being used – though that also came in for criticism.

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