Financial planning firms operating in-house portfolio construction functions face having to ‘FoFA-proof’ against looming operational risks embedded in the Future of Financial Advice (FoFA) legislation.
This is the view of specialist investment management group Select Asset Management (Select) which says higher consumer protection standards, including the onerous ‘best interest duty’ that applies to all product recommendations beyond 1 July 2013, has raised the bar for how financial planning licensees manage their risk of falling short of new requirements.
David Yale, Chief Risk Officer with Select, says the new regime fundamentally alters the operating landscape, especially for those groups running in-house portfolio construction and investment product models.
“We see an emerging world where non-aligned advisers will seek to maintain greater control of client relationship and outcomes, but also limit downside business risk as it relates to complying with the new standards.”
“So, there is a high degree of tension between those two ends of the advice business spectrum, particularly as the deadline for FoFA compliance begins officially on July 1,” he said.
What operational risk?
Select says advisers and licensees must have effective ways to equip their business against the risk of failing the best interest duty under FoFA. “I believe there are a number of aspects to this”, said David Yale. His top three issues for advisers to consider, under best interest, include:
1: Comprehensive research capability
Advisers will need to illustrate why each investment exists in the client portfolio. In other words: why is this asset in this portfolio, and why have certain other investments been excluded? There is a need to be across exactly what investments have been selected and why, and this needs comprehensive market and investment research expertise.
Mr Yale added, “There is a need for ongoing econometric and macro analysis to monitor market conditions and maintain an informed asset allocation view at all times.”
2: Real-time portfolio adjustment
Mr Yale said advisers would also need to consider how they keep client positions consistent with this overarching asset allocation view over time, requiring the capability to make timely, ideally real-time, portfolio adjustments.
3: Scenario analysis
Further compounding the complexity of best interest, Mr Yale said advisers should be equipped to respond to specific questions such as: ‘Why is a portfolio expected to meet its objectives?’ And ‘How might the client’s capital be protected in difficult markets?’
“Such analysis requires the application of sophisticated scenario analysis and stress testing techniques,” Mr Yale said.
“And sitting across all of this is a requirement for risk management capability that efficiently identifies, monitors and manages key risks and any unexpected investment behaviour.”
Mr Yale said the potentially onerous requirements of the new standards, such as the best interest test, had led certain dealer groups to find a better solution that primarily ticked three boxes: improved client engagement; FoFA compliant investment recommendations; and genuinely addressing the best interest principle.
“Various non-aligned financial planning licensees and dealer groups have met with Select to discuss their concerns, seeking ways to better handle the challenge of delivering excellent portfolio construction outcomes for their clients, whilst achieving compliance with the FoFA legislation.”
“We have developed an outsourced model, called Customised Portfolio Solutions or CPS, which is a bespoke model built to help these groups such as Profile, MGD Wealth, Stonehouse and DMG find a better, compliant, risk-mitigated way to run client portfolios.”
“The Select CPS service comprehensively equips dealer groups and advisers to deal with the operational and business risks presented by FoFA. In effect, the solution gives advisers the benefits of an investment management business but without the overheads or conflict – so enabling them to tick the best interest box knowing they genuinely comply with this upcoming and potentially onerous obligation.”