Creating and managing an investment proposition – part one
25 August 2020
By reading this article, you will learn:
- The various steps of the investment process
- How attitude to risk questionnaires can be used
- The importance of assessing capacity of loss
- How expected values, annual returns and drawdown can be expressed
- The attitude to risk agreement
- How asset allocation are optimised
Investment advice map step by step
For some initial context, I’d like to share something I call the ‘Investment Advice Map’ (below), which provides something that you can work with to provide:
1. A structured framework for your investment process
2. A separation between the various aspects of that process
3. Transparency of a business’ process
4. Flexibility, when it comes to utilising the various components
The process starts with client acquisition, which includes the usual fact find and collection of client information. However that element is outside of the scope of these sessions, but suffice to say that the key to adopting an investment advice process is the integration of the underlying tools being used by your business.
It’s important, from an efficiency perspective, to ensure that information collected at the fact find stage is held, and managed, within a back office system that easily integrates with research and portfolio management tools, together with chosen platforms.
Figure 1: The investment process diagram
The first step that I’m going to discuss is the ‘attitude for risk’ (ATR) process. Following that, in future parts in this series, I will talk about ‘investment solution selection’, ‘asset allocation’, ‘fund selection’ and ‘reviews’.
Other aspects of the investment process, which I won’t be covering, although they are equally as important are ‘platforms’ and ‘products’, as they tend not to be investment-related and may be driven by client or business-specific considerations.
Attitude to risk
To set the scene, let’s consider the regulatory landscape and steps in the ATR process.
Much of what can be seen in the ATR arena today is defined by the landmark document published by the then FSA in 2011 entitled ‘Assessing Suitability – Finalised Guidance’. That was updated, to a certain degree, in 2017 by GC17/4: Financial Advice Market Review (FAMR). I don’t intend to go through these regulatory documents but are highlighted for reference.
To look at the ATR process in details, I intend to cover the following:
1. What is ATR?
3. Capacity for loss (CFL)
4. Expected values, annual returns and drawdown
5. Agreed level of risk
6. Optimised asset allocation
What is ATR?
ATR is generally defined by a range of risk profiles - typically 3, 5 or 10 (the latter being the case for Defaqto Engage). Some providers like risk profiles to be time-bound and they consider the level of risk taken over a certain period of time – but I don’t necessarily believe in time-bound risk profiles as I prefer to consider risk profiles from a goals perspective.
I believe in having different risk profiles for different investment goals (which is facilitated in Engage). Goals can be short-term or long-term, vague or very specific. In this case, the investment solution is then associated with the goal.
Risk profiles themselves, tend to be defined by the level of ‘expected return on investment’ that the client can expect and the level of volatility that they may experience over the investment term.
Figure 2: Example of Defaqto Risk Profile factsheet
Most risk profiles are then fulfilled, investment-wise, using optimised asset allocations or a risk rated multi-asset solutions.
It is also possible that a client’s risk profile can be constrained by their CFL – more of which later.
Are they all the same? Well, just looking at two of the questionnaires available in Engage, it’s clear they are not. For example, the default ATRQ, developed in conjunction with A2Risk, has 12 questions, while an alternative one, developed by Oxford Risk, has 18 questions.
What they do have in common, is that they both offer a range of psychometric questions, normally answered using 5 predefined responses, from ‘strongly agree' to ‘strongly disagree’ with a ‘neutral’ option in the middle.
Figure 3: Example Defaqto ATR questionnaire
Based on a total of points allocated in respect of the client’s responses, they provide an initial risk profile. At Defaqto, we call this the ‘natural’ risk profile.
Its essential, at this point, to stress that this initial questionnaire process results in a risk profile that is just a ‘ranging-shot’. This should never be treated as the final risk profile but a way to open a dialogue with the client.
What about capacity for loss (CFL)?
FCA Guidance Consultation from April 2017 (GC17-04) provides guidance on assessing a client’s CFL:
It’s important to understand that CFL is not about how your clients see risk or their understanding of how their investments may perform, but their ability to absorb falls in the value of those investments.
I believe that capturing a client’s CFL is part of the dialogue that goes on between clients and you, as their adviser.
At Defaqto we have 2 ways of capturing that CFL. Either through a very basic percentage selection, using a tick-box approach, or through a series of more detailed question.
Once captured and agreed, that CFL is represented graphically on various projection graphs, which form part of the risk profile agreement process.
Agreeing clients’ ATR
As mentioned earlier, a ‘natural’ risk profile is not the end of the ATR process and the final step is to arrive at an ‘agreed’ risk profile with the client.
To help with this, ATR tools normally provide a range of both numeric and graphical projections to help the client understand what they can expect when selecting a specific risk profile.
At Defaqto, we provide a range of online tools together with offline support material to help you, as the adviser, explain the various aspects of each risk profile.
Graph 1 Example of a Risk Profile using stochastic modelling
Here we can see an example of a risk profile, which uses stochastic modelling to highlight a range of potential outcomes, that represent the most optimistic market conditions (5th percentile), average market conditions (mean) and poor market conditions (95th percentile).
As you can see, the original investment, in this example, is £100k and the CFL is set at 50% (£50k dotted grey line)
Depending on the ATR tool being used, care should be taken to consider how the tool represents these expected outcomes as they may differ from one system to another.
For example, outcomes can be displayed as:
- Cash-relative, or not
- Nominal or inflation-linked
- Inclusive or exclusive of: Adviser fees, Fund Fees, Platform fees.
It is also important to understand that illustrative lines, such as those above, are not designed to show the actual investment journey, but are simply reference lines for likely outcomes on the time/years scale (x axis). The actual journey, in terms of fluctuating values, likely to be more volatile in shape.
To assist with agreeing a client’s risk profile, and therefore ATR, it may also be useful to explain factors such as ‘maximum drawdown’, which indicates the potential falls in value that could be seen, relative to each profile.
At Defaqto we use plain English to explain that extreme 1 in 20 year events could occur that may result in significant falls in value.
Risk and volatility
While discussing likely outcomes it is probably worth spending some time understanding the volatility levels that exist behind risk profiles, even though these may not be presented to clients.
Together with a range of expected returns, each risk profile will also have an expected level of volatility and these will come together across the risk profiles to form a ‘risk scheme’.
At Defaqto we have, as already stated, 10 Risk Profiles, each of which has an expected annualised target volatility. These can be seen in the boxes to the left and right of the central shaded boxes, in the graphic. For example, risk profile 5 has a target annualised volatility of 10%, but also has a lower profile boundary of 8.3% and an upper boundary of 11.8%.
Figure 4: Defaqto Risk Profiles
This means that investment solutions that we risk rate as 5 will have expected volatilities within these boundaries.
The Defaqto boundaries also overlap, which provides a certain flexibility for those managing portfolios, be those fund managers or advisers.
Optimised asset allocation
Optimised asset allocations for investment solutions are linked to Risk Profile volatilities, in that they are combinations of asset classes that are projected to provide the best-expected returns for given levels of volatility.
Figure 5: Example Risk Profile 5 asset allocation
In this risk profile 5 example this is what we believe is the optimal asset mix, to provide the best return for the level of target volatility defined by the ‘risk scheme’ above.
The asset mix is arrived at through the use of individual market volatilities and a correlation matrix, which defines how asset classes interact over time.
For example, how do UK property markets behave when UK equities are going up or down?
A high correlation means if equities go up, property goes up as well. A negative correlation would mean they do the opposite – when one goes up, then the other goes down. And if they are non-correlated they behave independently.
All the steps in the ATR process have been completed and the client has an ‘agreed’ risk profile, which can be taken forward to the next stage in the investment process, which is the ‘investment solution selection’, which I will be covering in part two of this series.
Interested in learning more?
- Watch Creating and managing an investment proposition - part one webinar
- Risk tools – are they all that?
- How much risk are your clients really ready to take?
You might be also interested in other Insight articles.