Over the last couple of weeks, I have looked at aspects of the Myners report and, to a greater extent, the Sandler consultative document, both of which seem certain to lead to a fundamental change in the way in which financial advisers construct and present investment advice to clients.
When Ron Sandler finishes his consultation process and publishes his report, these recommendations will affect investment advice to individuals and companies, including advice given in respect of pension fund investments and – a topic of direct interest to Myners – investment advice given to the pension fund itself.
This week, I would like to look at what I believe will prove to be some of the most important and wide-ranging sections in the Sandler consultative document – sections 41 to 43.
Fundamentally, what these sections are suggesting is that financial advisers are pretty good at recounting the taxation treatment of different investment vehicles and applying those principles in determining appropriate vehicles for certain client circumstances. But we are not nearly as good at constructing appropriate portfolios within those vehicles.
Following up a particular aspect of the earlier Myners report, this document implies that not enough attention is given to the selection of appropriate asset classes and sectors within those asset classes. Examples which can be identified to support this include the arguable overuse of with-profits and managed funds, which often account for the entire value of a client's portfolio within a given recommendation.
In other words, the investment strategy – that is, apart from the selection of an appropriate investment vehicle – often comes as an afterthought rather than a key part of the advice-forming process.
Section 43 acknowledges the difficulties in the regulation of the quality of advice (rather than the compliant quality of a client file), without a doubt due to the subjectivity of portfolio construction and asset allocation within the portfolio. It is relatively easy for regulatory checks to ensure, for example, that a client file includes a properly completed fact-find, terms of business letter and reasons-why letter but it is not nearly so easy for those regulators to determine whether a particular portfolio is likely to answer the client's needs and circumstances properly.
Doubtless, the Sandler document, as well as the imminent Financial Services Markets Act regime, will seek to issue guidelines in this respect in the very near future but such guidelines will be extremely difficult to formulate due to their inherent subjectivity. Moreover, considerable degrees of variation will have to be permitted. I do not think anyone has any real idea of how this is going to develop but I am certain in my own mind that ongoing serious attempts at increased regulation in investment planning will be a feature of advisers' lives over the coming months and years.
What might this regulation seek to concentrate on in the short term? Regular readers of this column may remember a series on investment portfolio planning earlier this year – well before the publication of the Sandler consultative document was even conceived.
In that series of articles, I noted a number of core investment strategies which can (and should?) be used in many portfolio planning strategies. Here, I would like to summarise and expand on the most important of these, noting particularly the Myners recommendations and Sandler questions. They are, briefly, volatility, diversification, correlation and asset allocation.
First, as regards the volatility of asset classes, advisers should be aware that commonly held beliefs about the relative volatility of different investment options may have become outdated if, indeed, they were ever valid in the first place. As an example, it is widely believed that equities are the most volatile core asset class. However correct this assertion overall, where a client is considering a portfolio for its income-yielding qualities rather than its capital growth potential, he should be made aware of the fact that dividend yields from equities have risen consistently and with very little volatility over the last three decades.
The adviser must understand that the volatility of dividends is very different from the volatility of equity prices and this understanding should be carried forward to the likely future nature of these individual aspects of the total expected returns.
Equities are not the only asset class under which income and capital growth display very different volatility profiles. While commercial property values have shown moderate and sometimes high volatility over the last couple of decades, their rental yields have – similar to dividends – shown remarkable consistency.
Advisers must also understand that diversification does not necessarily result in a reduction in portfolio risk. The days are surely numbered when the limit of diversification for some advisers is simply to recommend a managed or with-profits fund for the entire level of client investment, believing that the diversification within the fund will reduce portfolio risk sufficiently.
Only slightly less efficient as a means of reducing portfolio risk is diversification of investment between, say, six funds with different providers but where all the funds are UK equity funds, which will generally display very similar price performance, barring more advanced diversification between UK equity sectors.
For diversification to reduce portfolio risk effectively, it must take place between asset classes and sectors which tend to behave in different and unconnected directions at any time. Contrasting examples are diversification between UK and US equity funds (which tend to behave in a similar way, meaning there is relatively little reduction in risk) compared with diversification between UK equities and property (low correlation of behaviour so a high reduction in portfolio risk).
This crucial principle will, I strongly suggest, be an important part of forthcoming regulatory guidance.
Finally, and leading on from the principles around correlation, greater attention to the allocation of assets within a portfolio will, I am certain, be demanded. Indeed, the Sandler document sets out specifically to assess the applicability of Myners investment principles to insurance companies and collective investments.
Much more thought will have to be given to the percentages of each asset class and, in some cases, each sector within a portfolio, with justification for these allocations.
If my articles of the last few weeks give cause for concern that we will be even more tightly regulated, then my apologies. I firmly believe that developments in this area will be capable of quite simple adoption by advisers and will quickly be seen to work effectively for the benefit of advisers as well as their clients, providing further demonstration of the added value a client can derive from a trusted investment consultant.
Keith Popplewell is managing director of Professional Briefing