Risk and suitability are the two most common issues at the heart of client/advisor disputes. To comply with the suitability standard as an advisor, you must fulfil both “know your client” and “know your product” (KYP) responsibilities. Assessing a client’s comfort with and attitude toward risk is perhaps the toughest part of every advisor’s job.
But regulatory initiatives to measure and summarize investment fund risk are not helping advisors fulfil KYP obligations. In my opinion, even a basic product risk assessment – done properly – requires you to ignore Fund Facts to ensure recommended portfolios are well matched to clients’ risk tolerance.
Each Fund Facts contains – among other things – a summary risk measure. The vast majority of fund companies assess each fund’s risk using the method espoused by the Investment Funds Institute of Canada, which applies a fund’s standard deviation to a five-point descriptive scale ranging from “low” to “high”. Fund firms update these measures and the resulting risk ratings annually.
I examined risk rating changes for 56 funds over the past several months. About 75% of changes resulted in lower ratings – with most funds falling to low or low to medium risk. The new low-risk funds lost an average of 23% of their value in the most recent bear market. These funds spent an average of three years underwater (the round trip from peak to bear market bottom and back to a new high). The low- to medium-risk funds sported an average 41% loss, with an average of five years spent underwater.
I have never met a self-described “conservative” or “low risk” investor that is comfortable losing 20%-40% of his or her portfolio value – particularly when it takes three to five years to get back to even. So, disregard Fund Facts’ vague risk disclosure and adopt a simpler approach.
Figure out the broad asset mix of a proposed client portfolio – i.e., the percentage allocation to equities, bonds and cash. To paint a risk picture for clients, simply assume that the proposed allocation to equities gets a 40% haircut – or 50% if your recommended equities allocation seems more aggressive. And assume that bonds and cash just stay flat while equities fall.
In a proposed portfolio of 70% equities and 30% fixed-income, for example, the client’s worst-case scenario will see the portfolio fall in value by roughly 30%, and is likely to take three to four years to recover lost ground and reach a new high. Expect that kind of decline to happen every seven to 10 years on average.
Alternatively, there’s a great free risk/return illustrator that you can use to add more meat to the simplified approach above. Go to www.stingyinvestor.com; scroll down a little less than halfway down the home page; on the right-hand side, under “Tools,” you’ll see a link to “Asset Mixer.” Enter your client’s asset class weightings, hit “Submit” and you’ll instantly have a historical illustration that will help to paint an accurate risk picture for client portfolios. This will remind clients that bear markets are a natural part of investing.
Dan Hallett, CFA, CFP, is vice president and principal with Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.
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