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Risk profilers rebuff calls for unified rating scale

Risk profiling cover.jpgRisk profile companies have defended using different rating scales to the key investor information document prescribed in regulation, after an adviser recently called for a unified approach.

In a regulation session at Money Marketing Interactive in Harrogate this month, an adviser gained the support of other delegates when she asked FCA retail investments head Clive Gordon and FCA retail investments thematic team lead associate John Johnston why the the rating scales are not measured on the same levels.

The adviser said: “The risk-profiling tools are not linked up with the Kiid. The number is totally different to every other risk agency’s numbering. You have to translate it back into one to five, one to seven, one to 10. Can we have a more unified approach by all of the risk-rating agencies as well as the investment disclosure document to have consistent disclosure in that sector?”

Gordon responded that a standard risk rating scale is not something the regulator would mandate.

He said: “We feel that there are so many factors that it would be very difficult to come up with a one-size-fits-all risk profile.”

The Kiid uses a rating scale of one to seven and is based on a “synthetic risk and reward indicator” measurement. That measurement is based on the volatility of the fund by looking at past returns.

Distribution Technology investment committee member Jim Henning says this approach differs from many other risk-rating scales, including DT-owned Dynamic Planner, which use forward-looking value-at-risk forecasts.

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Henning says: “While it is understandable [not having a unified scale] may cause some frustration with advisers, having the choice of different risk-setting frameworks is preferable to a one-size-fits-all solution. This is because it is important to differentiate between what various fund risk-profiling tools are trying to achieve. Combining forward and past performance-based fund risk assessment seems a sensible approach for advisers looking for suitable investment solutions.”

Finametrica director Paul Resnik says his company uses a seven-point risk profile scale to determine a client’s tolerance to risk.

However, he adds: “The Finametrica methodology has developed over many years as a scientifically proven way to accurately assess clients’ risk tolerance globally, rather than a narrow focus on the UK market.

Resnik says: “Our seven risk tolerance categories are not linked to the seven-point scale in Kiid documents. The scale used in Kiid documents exists to illustrate different fund risk categories, not clients’ risk tolerance. They’re measuring different things.”

Morningstar’s risk rating scale is from one to five and EMEA chief investment officer Dan Kemp says the most important thing is that any rating scale takes into account a client’s psychological ability to accept risk, their capacity to withstand loss and the timeframe of their investment.

Kemp says: “I don’t think the number of bands is especially important providing it meets those three criteria. What is important is how we estimate the risk of the portfolio or the investor to place them in those bands and how we monitor that risk and express that risk and what happens if a mismatch happens between the client and the portfolio.”

Kemp adds: “We would agree that a more unified system and understanding of risk would be beneficial for the end investor and the profession as well. I share some of that adviser’s frustrations.”

Risk-profilers recently faced tough questions after a report showed how, even at the same risk rating, the tools can go on to produce asset allocations that differ significantly.

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Comments

There are 6 comments at the moment, we would love to hear your opinion too.

  1. Turkeys don’t vote for Xmas!

  2. If risk profilers unified profiles and KIIDs onto the 1-7 scale, it would risk misleading the public into thinking that they meant anything.

  3. Absolutely right! And because there’s no common standard or approach to measurement, it makes all the systems on offer equally useless and unhelpful, and until there is commonality,and it’s clear the FCA aren’t about to enforce or encourage any, the only reason for using a bought in system is a misguided belief that it will give you protection in the event of a future complaint.

    I speak as a sole practitioner, and for multi RI firms a system, whatever it’s flaws, is no doubt essential. For a small 1 or 2 man firm however, in my view an IFA who knows his client and really understands risk, both Capital and Volatility risk, and also both the upside and downside of accepting risk, and properly understands the characteristics of the asset types he is recommending, is capable of doing a better job than any system, and furthermore is less likely to find him/herself with a dissatisfied client.

  4. Of COURSE there are multiple answers to the same question on asset allocation….!!
    If you want to choose four numbers that equal 10 for instance:-

    1+1+1+7
    1+2+2+5
    1+2+3+4
    2+2+3+3

    etc,. etc., etc….

    They’re all perfectly valid routes to achieving the same result and the same is true of blending asset classes.

    • They are indeed all examples of how to achieve 10, Jaime, That means each has a mean score of 2.5.

      However,the mean is not the only type of average. In the first example you give, the median and the mode are both 1 and in the third, what does the 1 tell us about the real risk our client is willing to accept.

      In the event that things go wrong you can guarantee that is what they will concentrate on – and you are likely to need to persuade FOS that they understood and accepted the higher level of risk.

  5. I think most advisers and investment manufacturers realise the risk-rating analyses serve principally as a defence against future claims if investments end up disappointing. Imagining them to be helpful in determining the likely outcomes of an investment with regard to a client’s capacity for loss or investment objectives would be pretty naïve.

    A regulator certainly isn’t going to be too prescriptive as to methodologies for fear investors would no longer be able to receive compensation from industry participants if it turns out to be useless.

    It still surprises me that European regulators have agreed on a standardised approach (using volatility as an indicator of risk); not particularly because it’s an easily abused measurement that will lead to huge losses from “low-risk” funds, but because it opens regulators up to compensation claims when investors suffer big losses in the investments sold as low-risk.

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