In this article, we explore the process of selecting and recommending a suitable fund (or portfolio of funds) for your client, while ensuring it takes into account any existing assets your client may have and the client's desired investment term.
The following 5 steps outline the key benchmarks advisers should have clearly in mind when selecting and recommending suitable funds for their clients.
1. Delivering consistency in the advice process
The design and implementation of a consistent advice process is key to recommending suitable funds to clients. This means using the same structured approach with all clients, on the understanding, of course, that everyone has individual requirements.
Fund recommendations are made at a specific point in the advice process, namely after you've completed a fact find with your client. At this stage, you will already have ascertained the client's attitude to risk, which is likely to be established through:
- the completion of a fact find and attitude risk questionnaire
- a discussion about his or her capacity for loss
- a good understanding of his or her investment objectives
2. Design a solution
Once you have sufficient details about your client's current situation and future needs, you can begin to design an appropriate solution for them. Your actions at this stage are likely to include:
- selecting an appropriate product type, taking account of your client's tax position and any other requirements
- carrying out a charges comparison between potential providers
- making a choice between funds that meet your client's requirements and objectives
3. Agree the investment term
When making a selection of appropriate funds, you need to take into account your client's expected investment term. This is an area which the FCA takes extremely seriously.
You will need to consider:
- why establishing a time horizon for your client's investment is important, and;
- how fund recommendations can vary over time, even for a single risk profile
If, for example, you were to ask a sample of your clients about which type of asset they consider the least risky, cash would probably be the most popular answer. And certainly, for money to be accessed in the short term, this is likely to be accurate. If they invested £10,000 in a deposit account today and then wanted to withdraw it one-month later, the chances are that they would receive £10,000 back. In addition, they would probably still be able to buy goods to a similar value. On the other hand, if this amount was left for five years, although they may still receive £10,000 (and maybe a small amount of interest), the impact of inflation may have reduced its spending power.
Let's assume 'risk' to mean the probability of an investment losing its value over time. Inflation risk (the probability of an investment losing its value compared with prices) is a major factor when an investment in cash is being considered.
Cash has also proved to be an increasingly volatile investment over time. The following diagram demonstrates that, although in recent years there has been little or no movement in interest rates, over the longer term, there has been considerable change.
An investment in equities should be treated differently from investments in cash. Due to the potential daily price changes in this type of asset, they are considered to be, in the short-term, a more risky investment than cash. If, for example, the client had invested £10,000 in equities and then sold them six months later, there is a chance that the investment might have grown to, say, £11,000. Alternatively, it could have fallen to, say, £9,000. Over this period, therefore, the probability that value will be lost is greater with equities than with cash investments.
In another scenario, let's imagine that this investment is left for five years. There can be no guarantee over the final return but is generally recognised that overtime an investment in equities becomes less risky. This is because the probability of it losing its value reduces.
As a result of these differences in behaviour, a fund's volatility and therefore its risk profile, can change over time.
4. Consider existing investments - diversification affects risk
A well-diversified portfolio (one that includes a mix of shares or asset classes) is likely to be less risky than a portfolio that focuses on a single company or market sector. This is because, at a given point, where a particular type of share is falling in value, another one within the same portfolio is likely to be rising in value.
Let's take an example where a portfolio consists of shares in ice-cream companies and also raincoat companies. At any given time, one of these is likely to be rising in value while the other is falling, due to market conditions.
The advisory process is not about simply recommending a fund (or funds) that matches a client's risk profile. Any other investments held by your client also need to be considered in order to ensure that the overall solution, including your new fund recommendations, aligns with the client's risk profile.
Even if your client has just one other fund and it matches their risk profile, you cannot be certain that, by selecting a further fund with the same profile, the overall result will be as expected.
5. Select an appropriate fund
A further consideration for clients involves having a clear understanding of the underlying objectives for the fund manager of the fund being considered.
Let's look at two funds (funds A and B) that are launched at the same time. Both invest 70% of their asset allocation in a spread of UK equities and the rest in a mixture of cash, fixed interest securities and corporate bonds. Unsurprisingly, they receive the same risk rating of 7 on the risk profiling system used.
Moving forward twelve months, equity markets have risen substantially therefore the fund's value has increased by 20%. As a result, the equity content of the fund has risen to 90% of its asset allocation. Its risk rating has also increased to 9.
The manager of fund B has taken a different approach and has concentrated on maintaining the balance of equities. As values have risen, the manager of fund B has sold equities, converting them to less volatile assets. A year after launch, the value of this fund has risen by 10%. Fund B's risk rating has remained at 7.
Surely, on the face of it, fund manager A has done their job more effectively. Certainly investors in fund A, receiving their annual statements after one year, are likely to be very happy with their results.
We will now move forward a further twelve months. Equity markets have fallen with the result that fund A has lost all its growth from year one. Fund B, although affected by the market, has experienced a much smaller loss and its value is still greater than at launch.
Now, who is happier?
Although fund B's performance has been less spectacular than fund A's, it has achieved its objective of maintaining its set risk profile.
In this example, there is no right or wrong strategy as far as the funds are concerned. However, in a situation where you are required to recommend a risk-based solution to your client, the possible future behaviour of a fund must be considered.
There will always be a range of factors that can impact the performance of a given investment portfolio, but getting the balance between assets consistently right and in-line with your client's goals and attitude to risk is a clear priority for advisers and a requirement from the FCA. Ultimately, it ensures that the advice the client receives is of the highest standard. Advisers can the issue recommendations that take into account a client's existing assets, by blending existing and new funds together and matching them to the clients profile. This ensures that rather than delivering a "one profit fits all", advisers can offer investment solutions that are individually tailored to each client with minimal effort.