How to assess the risk of managed funds

Assessing a client’s risk appetite is key in multi-asset investing. Maria Merricks reports on the compliance issues advisers need to be aware of.

There has certainly been a lot of noise surrounding the Managed sectors of late. Not only have their Active, Balanced and Cautious labels come under increased scrutiny, but this year also saw one of the UK’s major retail banks – Barclays – served a £7.7m fine for mis-selling products in the space.

However, funds from the Managed sectors remain a popular choice for investors and advisers. In its latest figures (April 2011), the IMA reported total net retail sales of £175m for the Cautious sector, £126m for the Balanced and £46m for the Active. The appropriate multi-asset funds will serve an investor well, but how can advisers ensure they are getting it right? A useful starting point is the Barclays case.

At the beginning of the year, the FSA ruled the bank had mis-sold the Aviva Global Balanced and Cautious Income funds to 12,331 people between July 2006 and November 2008, resulting in a total of £692m being invested. Chastised for its ‘serious failings’ the regulator said Barclays had failed to take into account the main considerations when recommending any investment product: a customer’s financial circumstances, their attitude to risk and what they hope to achieve by investing.

Assessing risk

So, how can advisers prevent the same thing happening to them? According to Andy Gadd, head of research at Lighthouse Group, the main point of reference should be the FSA’s Assessing Suitability paper, published in January 2011. In it, the regulator highlights the importance of a client’s capacity for loss which should go some way to indicating the client’s risk level.

The FSA defines capacity for loss as “the customers’ ability to absorb falls in the value of their investment. If any loss of capital would have a materially detrimental effect on their standard of living this should be taken into account in assessing the risk they are able to take”.

To establish this, Gadd suggests asking questions along the following lines: When do you intend to use the investment? How much of that investment could you stand to lose without significant impact on your future standard of living? If you need sudden access to a lump sum, how likely is it that you would need to encash that investment?

Many advisers use risk profiling tools and a number of providers offer psychometric profiling resources. However, this is another area the FSA has warned on. Gadd says: “The FSA quite rightly say use of these tools is only part of the risk profiling process. For me, that is common sense: investment is an art, not a science.

No one is able to ask questions, tick boxes and end up with an accurate view of a client’s risk profile. Every client is different. Risk profiles determine asset allocation, which is one of the most important detriments of future return, so while these tools are a useful addition to the process, you will need to prove how you got there.”

Advisers at Lighthouse use the Distribution Technology risk profiling software and have adopted a 20 question questionnaire. They send the questions to the client prior to the first meeting, enabling them time to consider their response so they can be discussed even further.