Financial Planning Case Study
The problem: I have read so much about risk recently, particularly as it relates to my pension fund and personal investments. Can you please explain your understanding of how much risk both you and my discretionary manager are taking with my investments.
The question raised is vitally important and one that must be clearly dealt with for all clients regardless of their attitude to risk.
The size of the issue can be illustrated by considering the difference between what a financial adviser, a discretionary fund manager and a client might regard as low or high risk.
A portfolio invested for high-risk growth would allow a discretionary fund manager access to equity and other investments on a worldwide individual basis. To an IFA, it might mean international growth funds. But to a client it might mean a small amount in UK blue chip equities.
This can create massive misunderstandings which can result in very bad outcomes for all concerned. It is no use labelling different strategies or funds with a risk label or number if the definition of that rating is not fully understood.
The starting point has to be the client’s expectation. It is only right, as an independent adviser, that input is given to this understanding, particularly for longer-term investments and the need for asset-backed investments.
However, everyone concerned with a portfolio must be of the same mind when it comes to the risk of that portfolio, regardless of the different labels that might be attached to it. One of the easiest ways of dealing with this conundrum is to look at capacity for loss.
Recently, a client was looking to place funds with a fund manager on a discretionary basis. After exploring these different avenues, the fund manager said to the client: “If we meet in three months’ time, while you will not like the result, you fully understand that your portfolio could be worth half of the money you give me today.”
This very clearly identified the fund manager’s definition of a higher-risk growth portfolio. As can be imagined, the client’s response to this statement was to reopen the discussion about the different risk ratings and a medium- growth portfolio was chosen.
What is interesting is that this portfolio was for a pension fund and on a pension fund risk basis, it could be argued that while the fund manager now viewed the portfolio as medium risk, from a pension perspective and certainly from a client’s perspective, it was still regarded as high risk.
Never is the case that one size fits all so wrong. This is becoming more and more evident as different fund managers, following regulatory and compliance pressures, are steering to use similar expressions for fund risk ratings to cover different risks.
The use of derivatives and third-party guarantees for certain other funds being a further example, particularly when used for so-called low-risk funds.
Each individual client differs and for individual portfolios, whether that be personal wealth, trust money or a pension portfolio, each client must fully understand their capacity for loss for each of those individual portfolios. They must ensure that each portfolio is invested appropriately with the correct labelling associated to the institution taking the investment, particularly if the labelling is different for the various portfolios of one client.
Issues to look for
The normal “know your client” information particularly with regards to other investments and future plans
Make sure the client’s definition of a risk category is the same as yours and external fund managers
Having agreed a risk category, ensure that this meets the client’s capacity for loss
Richard Jacobs is managing director of Richard Jacobs Pension and Trustee Services