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Morningstar investment head: Risk profiling tools ‘dangerous’

Advisers’ use of risk profiling tools is “dangerous” and likely to lead to complaints, it has been claimed.

Morningstar Investment Management co-head of investment consulting and portfolio management Dan Kemp says most risk profiling tools are based on false assumptions, inadequate statistics and can lead to clients investing in unsuitable funds.

Speaking at the Institute of Financial Planning’s annual conference in Newport, Kemp said: “Mapping a client to a portfolio is like trying to finish a jigsaw with a piece from another jigsaw. You can do it, but only if you simplify the shape – and that is one of the most dangerous things we are doing as an industry at the moment.

“There is a suitability gap, and that will lead to complaints the next time there is a downturn in the market.”

He said most risk profile tools use historic volatility as the key metric for measuring risk, which he argued is wrong.

Kemp told delegates: “Volatility is part of the solution, but advisers also need to consider other measures, such as valuation metrics.

“Advisers should take a more holistic view of risk. Do not allow any tool to overcome your skill as a planner when building portfolios. And if you are going to use tools, make sure they are robust and you know what assumptions they are based on.”


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There are 11 comments at the moment, we would love to hear your opinion too.

  1. Yet more generalised instructions with no practical follow-up relating to risk profiling. If anyone is interested, there is a link to Morningstar’s risk profiling questionnaire from 2012 below which asks only 7 questions, most of which relate to volatility. There are also some nice graphs showing examples of volatility. So that was their own standard just 2 years ago. I can’t find the updated version but I bet there are no/very few examples of the use of “valuation metrics” in it.

    If someone wants to make a statements like this they should follow it up with practical guidance and examples of how they have incorporated the statement into their own practices.

  2. Couldn’t agree more. When I first read the FSA Paper a few years back, it was clear to me that what they were saying is “do what you’re good at, engage with clients, you don’t need risk profiling tools”. We believe in educating the client by sending information about different types of risk beforehand, then discussion with the client, all documented, then agreement and then confirmation. Risk profiling tools can be used along the way to assist, but personally I wouldn’t go near them.

  3. Suggest consider the alternative approach – the Synaptic Modeller tool that is built around the Moody’s (B+H) stochastic engine. You can then model full range of possible investment outcomes yourself, avoiding the pitfalls of volatility based ratings and ‘qualitative overlays’. You can also access the Synaptic Attitude to Risk Questionnaire for free should you wish to recommend portfolios that have been risk rated using the stochastic methodology.

  4. This is the second time in a week Ive heard an ‘expert’ warn of the dangers of relying on risk profiling tools but abosolutely no suggestion or guidance as to what we shoudl use or do!

    It’s very easy to walk into a room and pull the pin on a grenade, drop it and walk out!

  5. As mentioned by Stephen, I am somewhat concerned that many investment managers suggest that risk profiling systems do not work. I am interested in what the alternative is to all the current systems, Morningstar, Synaptics etc. If the industry has something better can we have it please!

  6. Not much changes in financial services as the FCA/FSA warned a few years ago about the overreliance of risk profiling tools but in the same breath fines Sesame advisers for building their own portfolios.

    I totally agree that advisers need robust systems in place but what is the point of advisers taking all of the exams and become competent advisers only to be told by a risk profiling system that you should X amount of money in a particular sector and not take any consideration of current market conditions or the volatility of that particular asset class.

    To me what this highlights is the need of advisers to keep their knowledge up-to-date and to make sure that they are reviewing client’s portfolios on a regular basis. Surely that’s just common sense and overreliance on computer tools is always dangerous!

    What happens when we get computer-based advice when the underlying programming is incorrect, surely this opens up major questions the people developing such computer-based advice systems?

  7. Simplistically the risk of a tool is over reliance…….you end up with “computer says X……” profile, with the danger that neither the adviser nor the client fully understand what, why or how.

    Not saying tools are worthless at all, just that they are only what the term “tool” suggest – potentially useful if you know what you’re doing, but not the be all / end all.

    A few standard question may kick off a starting point, but then risk should involve a discussion with the client, with reasonable notes made.

  8. I think this issue highlights the importance of good quality, personalised financial planning. For most investors risk would be understood to reflect the likelihood of losing cash and the impact of a loss (i.e. how much they could lose). Neither of these events is easy to predict with any definitive accuracy and advisers need to use their skills and experience to help investors understand the investment options open to them and how these investments can be expected to perform in different scenarios. For example, corporate bond funds are likely to fall in value as interest rates rise (and vice versa) but the gross redemption yield should only be affected by credit issues with the bond issuers; less developed equity markets are likely to see greater falls in economic downturns than more developed equity markets.

    Helping clients understand the risks to their capital, ideally with some historic examples to help them contextualise the issues, seems to be the best route to take (and obviously it needs to be well-documented to counter the propensity of clients to have memory loss directly correlated to any investment loss).

    The metric arrived at by Europe’s regulatory bodies (CESR) which uses volatility as a proxy for risk in UCITS (SRRI) may work very well for fund promoters (who presumably lobbied in its support) but is pretty useless for investors and advisers (who will be the ones paying for it when investors lose money). It’s sometimes fun to build “low risk” portfolios consisting of sub-investment grade emerging market bond funds and iliquid property funds, but probably best not to use them for clients who don’t want to lose their money (or access to it).

  9. @CliveMoore

    Good common sense prevailing here. The bottom line is that you should only use a risk profiling tool as a start point for a discussion. Using experience and gaining client understanding is essential for obvious reasons.

    There is no reason why using a profiler to give you a start point cannot proide a basic framework for that discussion. @chipping sums it up nicely

  10. So, how do we actually agree and document attitude to risk. When it does go wrong everyone will have selected memory loss.

    Advisers need a regulated approved method and we should insist on it.

  11. Thank you everyone for your comments.

    To provide a little more context to the above comments my presentation focused primarily on the way the output of the risk tolerance questionnaires is used to map clients to portfolios. Most risk tolerance questionnaires (including Morningstar’s) include both volatility and capacity for loss questions, both of which are really important in the assessment of a client risk profile. However, volatility is a poor way of assessing the risk of portfolios as it has little predictive power. In the second half of my presentation I talked about ways to improve the risk assessment of portfolios. The use of these metrics is already incorporated in the Morningstar investment process.

    We are always looking for ways to engage with advisers and so please get in touch if we can be of further help.

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