In April, the Mutual Fund Dealers Association of Canada released a member regulation notice on suitability guidelines designed to help MFDA members set up a suitability framework to fulfil related obligations under securities law. Overall, the notice (MR-0069) is a good general guide. The MFDA’s view on risk assessment tools, in particular, touches on some important lessons for dealers and advisors.

The notice alerts MFDA members to a number of potential risks. In particular, the notice highlights the fact that a client’s suitability (or “know your client”) details in the dealer’s electronic file often do not match the same information in the paper file kept for the same client. The notice also promotes transparency in how risk assessments translate into specific investment recommendations and also warns that some risk-assessment methods overstate a client’s true risk tolerance.

On the issue of risk assessments, the MFDA is critical of many methods in use across the industry, particularly weighted average risk scales. For instance, a client assessed as “medium risk” might receive a risk tolerance rating of five out of 10, with investment funds rated on a similar scale. This client could then receive a recommendation to divide investments evenly between high-risk (with, say, a risk rating of nine out of 10) and risk-free investments (risk rating of one). A risk assessment of this investment recommendation, then, would go something like this: (50% x 9) + (50% x 1) = 5 out of 10, matching the client’s assessed risk tolerance.

The concern is that this may be unsuitable for many “medium-risk” clients and that clients may be unaware that they’re investing so much in high-risk funds despite the “averaging out” to medium risk on the advisor’s scale. The MFDA is implicitly assuming that, in many cases, nothing else is done to ensure suitability or to establish common-sense investment policies. To the extent that this is true, the MFDA has a valid concern.

Advisors using such simple, weighted average risk assessments are asking for trouble if they are doing little else to profile clients and ensure the suitability of recommendations. There is nothing wrong with such risk scales, but they are only effective when paired with some common-sense investment policies and the good judgment of an experienced advisor.

For instance, the advisor of our hypothetical client above could overlay policies such as a maximum allocation to high-risk investments (e.g., 0%-10% of total portfolio allocated to investments rated 8 to 10) or a minimum allocation to low-risk holdings (e.g., 25% allocated to investments rated below 4).

A useful tool can be obtained by matching these common-sense policies with this simple risk scale. And that’s before speaking to the client about his or her investing experience and other pertinent details to gain still deeper insight.

Similarly, advisors and dealers should not assume that a profiling questionnaire is complete enough to fulfil their KYC obligations just because it accompanies a popular software or wrap program. Too many questionnaires are not sufficiently robust to address a client’s willingness, capacity and need to take risk. And this assumes that the client’s risk definition is the same as that embedded in the questionnaire.

Few, if any, questionnaires fully capture the information necessary to make investment recommendations and fulfil KYC obligations. So, use these tools as they are intended — as guides — and use inconsistent questionnaire responses as an opportunity to educate clients further. IE

Dan Hallett, CFA, CFP, is president of Dan Hallett & Associates Inc., which provides a mutual fund recommended list and investment research to financial advisors across Canada.