Risk profiling – APT Strategy’s view

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This paper examines alternative views held about risk profiling. Key findings are that the there is a considerable difference of opinions in respect of what “risk profiling” really means and what is required by law. The paper also identifies a number of issues about risk profiling that remain unresolved. It concludes that debate on this topic to date has been inadequate and suggests that this has contributed to poor outcomes for financial planners and their clients.

As a starting point it must be recognised that risk profiling is not a clearly defined term. Consequently we may each have our own view of what “risk profiling” means.

For example, a view expressed by the FPA is that risk profiling is any of a variety of techniques used to classify clients into categories along a spectrum typically ranging from “Conservative” to “Aggressive”. (FPA, 2003, p 6 )

An alternative view, expressed by Wes McMaster, is that risk profiling ought not be linked to the psychology of the client, but that we need to ask the question: “How would the financial capacity of the client be affected if they suffered capital loss or the expected benefits were not delivered?” (McMaster, 2007)

What does the Corporations Act require?

The Corporations Act 2001 says nothing about client risk profiles.

What does ASIC require?

ASIC’s RG 146 mentions client risk profiles under the headings:

  • “Theories of investment, portfolio management and management of investment and risk”; and
  • “Identify client objectives, needs, and financial situation” (ASIC, 2008)

but gives no clue as to:

  • what ASIC means by the term “client risk profile”, or
  • how a risk profile ought to be assessed, or
  • how a risk profile ought to be used.

ASIC’s RG 175 does not use the term “risk profile” at all, but in RG 175.104 refers to:

  • “tolerance of the risk of capital loss”; and
  • “tolerance of the risk that the advice (if followed) will not produce the expected benefits”; (ASIC, 2007)

but does not clarify what ASIC means by “tolerance of the risk”.

In short, there appears to be no legal or regulatory obligation to adopt any particular risk profiling methodology. This conclusion is supported by the FPA which states that “Risk Profiling is not required in ASIC PS 175”. (FPA, 2003, p 6)

On the other hand, McMaster is reported to have said that while there is no benchmark to measure the quality of risk profiling it is virtually mandated through the “know your client” legislation and that in cases where he has given expert opinion “it was clearly evident that the advice given didn’t match the risk profile” (FPA, 2005).

Alternative industry views

This absence of guidance by ASIC has left the industry free to make up its own mind about risk profiling and vulnerable to the pressures of “compliance experts” who peddle their own views and marketers of products designed to measure risk tolerance.

The range of views is illustrated by the fact that:

  • Finametrica has developed and markets a psychometric test to measure risk tolerance, (Finametrica, 2009) while
  • Wes McMaster has questioned whether risk profiling should be linked to the psychology of the client. McMaster interprets “tolerance” to mean “financial tolerance” and suggests: “ASIC is asking us to do a simple sensitivity analysis to test how the probability of different outcomes would affect the financial capacity of the client.” (McMaster, 2007)

ASIC’s view as per RG 175.104

 In order to understand ASIC’s intention it is important to read the note that follows RG 175.104 for this note makes it clear that RG 175.104 is all about clarifying how ASIC believes “relevant personal circumstances” (as defined in s761A of the Corporations Act 2001) ought to be interpreted. In particular, the note states that the matters listed in RG 175.104 are not an exhaustive list of “relevant personal circumstances” and that one ought to consider “any other matter that would reasonably be considered to be relevant to the advice. This would normally encompass any matter that the client indicates is important.” (ASIC, 2007)

That is, RG 175.104 is not telling us what to do, but giving examples of the sorts of things that ASIC suggests we should do to comply with the more general requirements of s761A. Following this logic one might also be expected to consider a client’s tolerance to the risk of:

  • loss of purchasing power in the long-term due to the expected combined effects of inflation, taxation, expenditure, and investment returns;
  • loss of liquidity due to freezing of funds as has happened with unlisted property trusts around 1990, Excelsior in 1993, and mortgage funds in 2008; and
  • loss of access to capital and loss of earnings as a result of legislative change;

In addition, the wording of s761A is so broad it could be argued that one ought to consider a client’s tolerance to risk of a wide range of extreme events such as the 1987 crash, the 2008/09 Global Financial Crisis, and other scenarios such as hyperinflation, deflation, stagflation, climate change, war, etc.

However, the global economy is very complex. Is there anyone who truly understands it? If anyone could reliably predict economic changes and market movements they could earn a fortune working for a fund manager, but the results of managed funds suggest that no such person can be found. The reality appears to be that the range of events that might be considered relevant is limited only by one’s imagination and that while many future events may seem unlikely to occur, with the benefit of hindsight most events can seem foreseeable. Furthermore, those events which past data, experience, and existing beliefs may suggest are the most likely may never occur. This is a fundamental issue.

  • Is a financial planner really equipped to consider such matters?
  • If a financial planner were ever pressed by ASIC, FICS, FPA, or a court to demonstrate that such matters had been considered what level of documentation would be considered adequate?

Also, only two of the nine examples provided in RG 175.104 relate to risk tolerance. That is, ASIC’s interpretation of s761A goes way beyond the need to consider risk tolerance to an array of unspecified events. Risk tolerance is just one aspect of what ASIC believes is meant in the Corporations Act by “relevant personal circumstances”.

The breadth of ASIC’s interpretation of the meaning of “relevant personal circumstances” has major implications because:

  • s945A(1)(a)(1) requires that the providing entity “determines the relevant personal circumstances”;
  • s945B gives an obligation to warn the client if “the advice is based on information relating to the client’s relevant personal circumstances that is incomplete or inaccurate;
  • RG 175.93 requires the licensee to keep records for the following matters for at least seven years from the date that personal advice is provided to a retail client:
    • the client’s relevant personal circumstances as determined under s945A(1)(a)(i); and
    • the inquiries made about those relevant personal circumstances as required by s945A(1)(a)(ii);

At face value the above obligations seem perfectly reasonable, but if one accepts ASIC’s interpretation of relevant personal circumstances then the above obligations are vast. This raises the question of whether ASIC’s interpretation in 175.104 is consistent with the Government’s intention.

The difficulty with 175.104 is that it includes the words “any other matter that would reasonably be considered to be relevant to the advice”. [Emphasis added] The breadth of these words is huge.

By contrast the words “any matter that the client indicates is important” which are also used in RG 175.104 are quite narrow.

O’Toole, a senior financial consultant is reported to have said “Regulators have put advisors in a ‘damned if they do or damned if they don’t’ situation … and then sat on the fence.” (FPA 2005)

Perhaps the Government’s principle based legislation was intended to simply create an obligation to use good judgment and common sense by considering “the person’s objectives, financial situation and needs as would reasonably be considered to be relevant to the advice”. After all that is what the law says. (Corporations Act 2001, s761A) The law does not suggest one ought to conduct psychometric tests or prepare sensitivity analyses.

Issues yet to be resolved
Irrespective of any obligation under s761A, s945A, etc. and irrespective of ASIC’s opinion there is a raft of issues in respect of risk profiling that appear never to have been resolved. These include:

  • whether any risk profiling methodology serves a useful purpose;
  • whether any risk profiling methodology produces consistent, valid and reliable results;
  • whether risk profiles remain constant over periods of boom, bust, and unexpected economic circumstances;
  • how risk profiling may be used by financial planners;
  • how often a client’s risk profile should be reviewed;
  • whether a client’s strategy or portfolio ought to be changed every time their risk profile changes;
  • to what extent a financial planner ought to rely on the results of risk profiling as opposed to their own judgement of what is appropriate; and
  • whether risk profiling improves or damages the quality of advice.

Also, the FPA’s report (FPA, 2003, pp 5,6) makes the following comments about risk profiling:

  • There is no concrete evidence that any process or method can accurately predict a client’s tolerance to investment risk.
  • The FPA does not prescribe methods Financial Planners ought to use to determine the capacity of their clients to withstand less than expected investment performance. This is a matter of professional judgment.
  • Financial Planners may also choose to assess and to employ methods for assessing each client’s psychological tolerance to risk. The need to do so and the methods employed are a matter for professional judgment.
  • After consultation, the FPA believes that “Risk Profiling” … and resultant pigeon holing, are contrary to the concept of tailored and customized advice. It is yet to be proven that the processes used for categorising clients are robust and that short-term market performance or the current political and economic environment does not affect attitudes. Furthermore, a client’s actual circumstances and objectives may be in conflict with their expressed attitudes and preferences.

For the moment, ignore the above issues and imagine that we have a psychometric test that has been proven to give consistent, valid and reliable results. What do we do with the results?

Do we simply match the person’s score to a predetermined asset allocation? For example, should a “conservative” person be given a 20:80 mix of equities and fixed interest? If this is the case then the next logical step is to select products from the AFS Licensee’s approved product list.

This suggests that giving “appropriate advice” is as simple as administering an approved outsourced psychometric test and using the approved asset allocation based on the psychometric test results to select products from the approved product list. Such a model for giving advice would be ideal for many businesses in that:

  • minimal knowledge would be required by the representative as they make no decisions – they simply sell the process to the client;
  • minimal training and supervision of the representative would be required;
  • the process gives the appearance of ticking the compliance boxes in terms of the form of the process of giving advice;
  • the approach is very marketable to gullible clients; and
  • it allows the AFS Licensee to control the products that are sold.

But, does it lead to good advice? Such a process could lead to a recommendation that a conservative investor should hold 80% of their investments in a diversified portfolio of fixed interest investments offered by the likes of Westpoint, Fincorp, MFS Premium Income Fund, and Australian Capital Reserve.

It is ironic that an authorised representative who follows this process may be held responsible for such advice even though the advice they gave was determined largely by the decisions of their AFS Licensee in respect of:

  • the psychometric test to be used;
  • how the results of the test would determine the asset allocation; and
  • which products would be on the approved product list?

Perhaps McMaster’s simple sensitivity analysis is the better approach to giving good advice. But which of the myriad of variables ought to be varied and what probability ought to be assigned to each event? Unfortunately, this process is subject to extreme bias and given the myriad of possible outcomes and the unknown probabilities it is questionable whether a simple sensitivity analysis would be meaningful. In fact, the more meaning that is attached to the sensitivity analysis the greater the risk that the financial planner will be seen to be giving a forecast and if the outcome is below the range indicated by the sensitivity analysis the analysis could be construed and being designed to mislead/deceive. In such circumstances it can be very difficult to defend oneself. This is because the future is very uncertain and even events which seem to have very low probability sometimes occur and once they have occurred it is difficult to explain why they seemed so unlikely. The financial planner who provides any sensitivity analysis is particularly vulnerable to criticism by others who with hindsight may dredge up evidence to suggest that other factors ought to have been included in the sensitivity analysis, or that the range of assumptions should have been broader, or that the probabilities ought to have been different.

Perhaps it is time for the industry as a whole to consider whether:

  • any process necessarily leads to good advice; or
  • good advice is the natural outcome of competent people, whose ethics are stronger than their conflicts of interests, exercising their judgment in a diligent manner.

If the latter is the case then perhaps less emphasis should be placed on the form of the process of giving advice and there should be increased debate about the advice itself. If such discussion had taken place prior to the Global Financial Crisis (GFC) perhaps the highly geared investment strategies that were widely promoted prior to the GFC would have been recognized as inappropriate for many clients before they lost so much money. If such discussion is not led by financial planners it is likely that the appropriateness of advice will continue to be judged by people who have legal training, but minimal knowledge of investing.

FOS’s view
Despite all of the above, it appears from past determinations by FOS (formerly FICS) that FOS is strongly of the view that asset allocations should be based on risk profiles and despite apparently basing many of its determinations on its views in respect of risk profiling FOS has not seen fit to share the basis of its views with its members whom it judges.

The unwillingness by FOS to expose such views to public scrutiny may have contributed to the FPA asserting that the “scheme’s transparency and processes need to be addressed”. (FPA, 2008, pp 4, 10)

All things considered the financial planner can be between a rock and a hard place if the investor loses money for it seems impossible to fully comply with the Corporations Act 2001, ASIC’s expectations, and be confident that FOS will find you innocent. This leaves the financial planner vulnerable irrespective of their competence, ethics and the quality of their advice. This vulnerability has led to a backside covering mentality which in turn has led to long, generic SOAs, and increased costs for consumers.

Summary

Meaningful discussion of risk profiling is difficult as the term lacks a universally accepted definition and ASIC’s Regulatory Guides do not clarify its views in respect of risk profiling. Thus, there are various views about meaning of risk profiling.

ASIC’s RG 175 has muddied the waters considerably by interpreting s71A of the Corporations Act 2001 in such a way that it appears to have taken a principle based obligation and blown it out of proportion to what the legislation was originally intended to require. ASIC’s interpretation seems hugely onerous. Most importantly, RG 175.104 leaves financial planners vulnerable to attack by FOS, FPA, or the courts because it would be virtually impossible for a financial planner to demonstrate that it had met ASIC’s interpretation of s761A.
In addition, there are various issues in respect of risk profiling that remain unresolved.

Despite the lack of definition, the murkiness of the regulatory environment, and the unresolved issues, risk profiling is used by many financial planners and FOS appears to regard it as an important aspect of financial planning.

The fact that the concept of risk profiling appears to have been adopted by FOS and so many Licensees while so many risk profiling issues remain unresolved suggests that the industry as a whole has more interest in the form of the advice and dispute resolution processes than the substance of the advice provided. This is a poor outcome for the public as it means that poor advice can be packaged so as to appear as if it were good advice.

Conclusion

The industry as a whole has failed to discuss the concept of risk profiling in a professional manner. Rather the discussion to date appears to have been driven by marketing reasons and it has lacked both sound basis and consideration of what would lead to a good outcome for the public.

This is understandable as the industry lacks any suitable forum for discussing such issues and is in stark contrast to professions such as medicine, law, engineering, economics, etc. which have professional journals which expose opinions to the scrutiny of peer review.
There is a clear need for a proper level debate of issues such as those raised in this paper. Until such issues are resolved there will be uncertainty about what is required by financial planners and what is good advice. The uncertainty is a poor outcome for both financial planners and their clients.

References:

  • ASIC, 2008, Regulatory Guide 146, Licensing: Training of financial product advisers
  • ASIC, 2007, Regulatory Guide 175, Licensing: Financial product advisers—Conduct and disclosure
  • Corporations Act, 2001 (Commonwealth)
  • Finametrica, 2009, https://www.finametrica.com
  • FPA, 2003, Policy Position – Risk Tolerance (Effective: October 2003 Position reviewed and confirmed: August 2005)
  • FPA, 2005, Risk profiling: rocket science or snake oil, Financial Planning Magazine
  • FPA, 2008, Financial Ombudsman Services’ Terms of Reference, Submission to the Financial Ombudsman Service
  • McMaster W 2006, Risk profiling – Has the financial advice industry got it right? http://www.wesmcmaster.com/publications/0607_Financial_Advice_Litigation.pdf

Comments

  1. Wow, this post is good, my younger sister is analyzing these things, therefore
    I am going to tell her.

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