The importance of full risk disclosure

Shaun O'Leary - Group Compliance Director

Ensuring that a recommended investment solution matches the amount of risk a client is willing and able to take is fundamental in providing robust and appropriate advice. This is often seen as mapping the asset allocation to the recommended investment portfolio – a key part of the risk assessment process.

Disclosure should evidence that asset allocation is consistent, and aligned to a client’s agreed risk profile. There should also be individual consideration and disclosure of the risk potential of each component part of a portfolio.

This has been reinforced by the FCA in their thematic review of wealth management firms and private banks (suitability of investment portfolios TR15/12), highlighting continued concerns that:

firms need to do more to ensure that the composition of the portfolios they manage (or recommend) truly reflect the investment needs and risk appetite of their customers

firms need to ensure that their governance, monitoring and assessment arrangements are sufficient to meet their regulatory responsibility in relation to suitability

It is therefore vital to make sure each client is fully aware of the potential risks associated with their portfolio. These include each asset class and any other influencing factors such as inflation and currency risk. A marker to the success of this should be a “no surprises” approach reducing the potential for client complaint on the grounds of insufficient risk disclosure and understanding.

Discussion should be held and recorded outlining the different characteristics and behaviours of each asset class specific to the investment being made, together with a breakdown of the asset allocation. This should be further supported with suitable risk warnings for each.

Where cash is held on deposit or in cash type funds, warning should be given as to the impact of inflation and the falling purchasing power over the longer term. Portfolios containing fixed interest assets will require comment on the risk of default and also the potential for price volatility due to interest rate sensitivity, creditworthiness and market liquidity.

Appropriate volatility warnings must be included with equity content especially where investment is into emerging markets, small start-up companies, commodities or specialist funds.

Increased volatility through exposure to a single country or market should also be highlighted.

Where property funds are part of an investment portfolio, warning should be given as to the reliance on the managers leasing the property and potential liquidity issues.

Discussion should be held and recorded outlining the different characteristics and behaviours of each asset class specific to the investment being made, together with a breakdown of the asset allocation. This should be further supported with suitable risk warnings for each.

Where cash is held on deposit or in cash type funds, warning should be given as to the impact of inflation and the falling purchasing power over the longer term. Portfolios containing fixed interest assets will require comment on the risk of default and also the potential for price volatility due to interest rate sensitivity, creditworthiness and market liquidity.

Appropriate volatility warnings must be included with equity content especially where investment is into emerging markets, small start-up companies, commodities or specialist funds.

Increased volatility through exposure to a single country or market should also be highlighted.

Where property funds are part of an investment portfolio, warning should be given as to the reliance on the managers leasing the property and potential liquidity issues.

The one area often overlooked when considering the overall risk of a portfolio is that of currency risk and the impact it can have. Where investments are made in currencies other than Sterling, changes in exchange rates may cause the value of the investment to rise or fall, exaggerating any increase or decrease in the value of the holding. Returns could be derived more from currency movement than the value of the actual underlying assets. But more importantly, is this level of additional risk consistent with what was agreed with the client at the outset?

The key message is to ensure each client is fully aware of all potential risks that could impact their returns.

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