17 August 2017
Lawrence Cook, director of marketing and business development at Thesis Asset Management, draws on the firm’s own experience to analyse the process of choosing a risk profiling solution.
To go right back to basics, the point of risk profiling is to ensure that clients get good advice leading to suitable investments that will help them to achieve their objectives.
A risk profiling tool can help to provide consistency and to give evidence that clients have received suitable advice.
It is wise to do detailed work on the tool you choose, or to design your process if you choose to build your own. Detailed analysis is needed whether you choose a third-party tool or design your own.
Let’s have a look at some things to think about when choosing a risk profiling solution.
First, how well does it suit your particular blend of clients? Do the questions fit with their knowledge and experience? A question that asks about the amount of investment risk taken in the past may be useful for a more experienced client, but less so for someone who is investing for the first time following an inheritance for example.
How much can you rely on risk taken in other areas? People may be risk takers in business or their sporting life but conservative with their finances, or vice versa.
Does the scale of outputs provide the right balance between sufficient granularity to differentiate between clients, but not so much detail that its output isn’t intuitively clear to the client? A five-point scale isn’t very useful if 90% of clients come out as a 3, but a 500-point scale is probably too detailed.
How does your risk assessment integrate with the rest of your process? What records does it produce? In a larger firm does it produce aggregate MI to monitor and evidence consistent suitable advice across different advisers?
You must assess capacity for loss as well as appetite for risk. Is this incorporated into the risk assessment, or is it another piece of work sitting alongside it?
Risk tools can help to take the emotion out of risk profiling, but they mustn’t remove the expertise and empathy. The adviser needs to review the tool’s output in the context of their knowledge of the client’s objectives and situation, and after a discussion with the client they may overrule the risk tool results. There is nothing wrong with that, as long as it is properly recorded.
The mapping part of the process is sometimes lacking, and needs a lot of care by the adviser. What we mean by mapping is the link-up between a client risk profile and the risk of the investment portfolio.
Some risk tools produce an asset allocation, but by following that you are implicitly accepting their investment approach. That may not be a bad thing, but should be a decision you make actively. A key concern for this approach is where the asset allocation is driven by a simplistic view of volatility. Volatility in an asset class may lead this type of approach to automatically reduce exposure to the asset. This can introduce some problems. If we suppose the prospect for this asset is very positive you might actually want the proposed level or even more of this asset, not less. Conversely an asset experiencing low volatility might mean the automated approach to asset allocation increases the weighting when the prospects may not be promising.
Some tools take a very black and white approach where assets are classified as either safe or risky. This doesn’t take account of the range of risks within an asset class (e.g. a blue chip UK equity fund faces very different risks from a small-cap emerging market fund). It also ignores the diversification that can be achieved by including uncorrelated or alternative assets in a portfolio.
It’s no good having a perfect risk profile for the client if you can’t then use that to choose a suitable portfolio. Obviously, this is where a good DFM will be happy to help in mapping their investment process onto the adviser’s suitability process.
Let us take a look at an example of risk mapping between a risk profiler and a DFM’s investment process. Here we are looking at eValue and Thesis Asset Management’s model portfolio range (see tables).
We know that eValue uses a number of different time horizons. This has seven levels of risk reflected in their model portfolios simply numbered 1 through to 7. The graphic below shows how the adviser can use the mapping to provide guidance on which investment portfolio is most suitable for his client.
We can see from this that the eValue score is matched to a Thesis investment portfolio number. For some eValue risk scores there are two Thesis portfolios potentially suitable. For example, in time horizon 3-5 years eValue risk score of 3 lies on the cusp between Thesis portfolio 3 and 4. This is because the implied asset allocation from eValue sits on the strategic asset allocation boundaries for Thesis. Like other DFMs Thesis changes its asset allocation periodically within ranges so risk is not static. The adviser performs a critical role in considering the overall picture of the client and deciding on balance what is the most suitable portfolio.
There is more to be gained in working with the DFM than the mapping itself. Experience suggests that an ongoing dialogue between an advisory practice and a DFM about investment risk and how that relates to client advice is beneficial to all parties. The records of such discussions can often be used by advisers as part of their investment due diligence and contribute to investment committee deliberations. DFMs won’t normally charge for such work and it is a good example of professionals within the financial services community working together to good effect.
Mapping the client to the portfolio (click image to enlarge)
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