What does MiFID, C.I.P. and investment risk management have in common?
For many advisers, management of investment risk is the big work in progress. Because of the various moving parts, gaining a single view of the problem is surprisingly difficult.
Many adviser firms are reluctant to tinker with advice formulas that they have embedded in their business, even though in some cases, the process is a mishmash of tools and assumptions that are long past their sell-by date. A risk being run is that the use of an Attitude to Risk Questionnaire (ATRQ) which they borrowed or downloaded 10 years ago, may have no research proving its correct alignment to an investment strategy. Similarly they may not have access to a measure for risk that they can apply across different investments and investment styles.
We would urge firms to consider the ground that is being prepared for future scrutiny and enforcement. A paper (TR16/1) was published in 2016 that established the central role of 'research' in the provision of compliant advice, and that poor advice was the result of 'poor research and due diligence'. The paper identified a culture in many firms that lacked 'challenge' and on-going reassessment. It highlighted an over-reliance on providers (particularly in context of platform selection), and criticised failure in firms to understand their 'own inappropriate bias towards products, services or providers'.
This theme has reappeared in multiple thematic reviews, and finds its full expression in the new MiFID II directives that seek to strong-arm advisers into additional due diligence to promote the interest of consumers. However, as several of our customers have pointed out, the more obvious headlines that have occupied compliance departments (such as disclosure of transaction costs, and the requirement of full proof of suitability at review) have obscured the further considerations posed by PROD (Product Intervention and Product Governance Sourcebook), even more directives that originate from the FCA and designed to ensure.. implementation of MiFID II.. hurrah!
PROD in fact requires firms to act as providers by insisting a firm's C.I.P. assumes some of the same responsibilities as a manufacturer. A nightmare if executed poorly, but if this initiative does succeed in aligning manufacturers, distributors and consumers it could be very powerful. The best outcome would be to see firms soaring through the red tape and greatly improving the quality of their advice.
That means that firms will need to have performed segmentation, and designed solutions that are appropriate for different tranches of clients. Target market disclosures are obligatory for all providers. In our parlance, this requires the building and maintaining of a C.I.P. based on segmentation, and performing due diligence (preferably independent of any provider) to demonstrate suitability. The emphasis in the paper is on performance of regular reviews to ensure compliance with the directives. The need for strict product governance becomes non-negotiable. When it comes to personal recommendations, firms obviously need to be able to demonstrate that the generic model represented by the C.I.P. maintains suitability at the level of recommendation.
The PROD sourcebook summarises a firm's (distributor's) responsibilities:
- disclosure (see COBS 4 and COBS 14.3A);
- suitability (see COBS 9A);
- appropriateness (see COBS 10A);
- inducements (see COBS 2.3A); and
- conflict of interest (see SYSC 10.1).
A quick survey of these requirements should be enough to prove that the FCA is very serious about ratcheting up the compliance responsibility of firms.
Which brings us to today's challenge: how to define an investment strategy that will help define the range of risk in a C.I.P and provide on-going proof of suitability regarding risk. What do we do?
A positive consensus is forming around the role of stochastic forecasting in the building an investment strategy. This assumes that the model in question has proven itself over the years (not all have). Moody's Analytics (formerly Barrie + Hibbert) are considered to be the leaders in this field.
By x-raying any investment, taking the asset allocation and applying forward looking projections for said investments, we can build a picture of the likely investment trajectory based on probability. Building your efficient frontier using the 'Value at Risk' measure, and other metrics produced by a stochastic model, is a better approach than working to a volatility based model. This is because stochastic forecasts can capture the investment trend, and forecasting 'viable' outcomes is increasingly proven to be more successful than reliance on volatility.
Crucially a stochastic approach gives you a range of values which you can use to discuss loss with your client. You can reasonably forecast the extent of losses in a bad year (the min gain), you can adopt a reliable growth assumption (the ave gain) and you can use the profile to demonstrate the asymmetric risk and reward ratio that drives long term investment gain.
Distribution of investment returns from simulation applied to Quilter MPS Balanced. 10 yr terms. £10k.
Min / ave / max gain values are included in the Synaptic risk profile
The risk and return dynamics of the Quilter MPS portfolios (in my C.I.P.)
Unlike competitors who have developed a culture of 'set and forget', Synaptic reviews asset allocations, projections and risk ratings every quarter so you can fulfil your duty to monitor risk exposure on behalf of the client.
The stochastic model
Mathematically captures the full range of 'viable' outcomes for an investment strategy, by identifying the different asset classes in the allocation and projecting their possible growth trajectories.
The efficient frontier
Thousands of portfolio variants are tested to decide on best asset allocations to form our Strategic Asset Allocations. Each quarter these SAAs are rerun through the model to test the boundaries between the risk categories. Thereafter, any investment can be mapped to the model, to create a consistent view of risk, that is always current.
The Synaptic Risk profile
This consists of min gain / ave gain / max gain. Perfectly captures the asymmetry of investment returns in favour of investor over the long term, and quantifies losses and likely gains along the way. The min gain value is the Value at Risk measure that is used to quantify likely losses in a bad year (1 in 20), to agree Capacity for Loss parameters with a client in a meaningful way.
Tactical vs Strategic
Very useful for advice where the strategic allocation can be used, but also allows for a manager's 'tilts' to be monitored.
We are often asked to supply a simple explanation of how our research process supports advice in the context of risk. Alas, no such simple guide exists, so this is my attempt at an overview. Key take away is the use of 'Value at Risk' (loss in portfolio in bad year, defined as 1 in 20), as opposed to Volatility banding.
Synaptic Risk is FREE. Why pay for an inferior methodology elsewhere? Call us on 0800 783 4477 or email us on email@example.com. We will give you a free log on to use the ATRQ and access to the quarterly updated tables. Both 1-5 and 1-10 accessible.