Chapter 12 – (15 QUESTIONS, 3 CASE STUDIES, 5 QUESTIONS EACH) The Investment Advice Process Flashcards
A high-level investment advice process, which fits within the general advice process can be defined as:
Step 1: Risk profiling
Defining objectives
Asset allocation
Fund selection
Wrapper selection
Platform selection
Investment Statement
Final step: Review
The final three chapters in this guide cover the investment advice process, how to construct portfolios for our clients and how we keep our clients informed on the performance of their portfolios.
Chapters 12-14 form the majority of the content for the final 15 questions. Remember these are split into 3 case studies with 5 questions for each.
In this chapter, we will look at the investment advice process including the ‘know your customer’ requirements, determining aims and objectives, establishing a risk profile, and presenting and justifying solutions.
Trust is not something that happens immediately; it needs to be earned throughout the four stages of the business relationship.
Service-based is about providing basic information to clients i.e. providing answers and facts in a timely fashion.
Needs-based is about solving problems and providing solutions.
Relationship-based is about providing ideas and different approaches to organise the client’s affairs.
Trust-based is where the adviser sees the client as an individual, understands their personal situation and concerns, and establishes a long-term business relationship.
12.1.2 Regulatory requirements
In order to provide investment advice, there are understandably a number of requirements that need to be met by firms giving advice that have been laid down by the FCA. These include:
Is the advice independent or restricted?
How broad or restricted the advice is.
Clients must be notified of their (the client’s) classification as one of either retail, professional or eligible counterparty.
Local and public authorities must be classed as retail clients.
These set out the essential rights and obligations of the firm and the client, so that clients have a clear understanding of the services that are being provided.
Include investment parameters, frequency of reports, and portfolio reviews.
Advisors need to ensure that they have the information required from their clients to ensure they can make a suitable recommendation.
Clients must be made aware of the importance of providing up-to-date information.
Advisers need to be aware of potentially vulnerable customers such as being recently bereaved, having a physical or mental disability, or experiencing impaired cognitive skills due to illness or age.
Vulnerability can be long-term or transient.
Advisers need to ensure that they understand the needs of vulnerable customers to ensure they are not at risk of poor outcomes.
Firms need to ensure staff are trained in spotting vulnerable customers and understand the action that needs to be taken, including ongoing monitoring and evaluation of their needs.
Firms are required to provide specific information to the client about the firm, its services and charges before they make a recommendation.
We’ve included the main information areas here:
Information about the firm:
o the name and address, details of the regulator that has authorised them, methods of communication between the firm and the client, how frequently they will provide performance reports to the client, and the conflicts of interest policy.
Information about the service:
o whether it is independent or restricted, and how broad or restricted that advice will be.
Information relating to managing investments:
o how frequently investments will be valued, benchmark specification, types of investments that may be included and the client’s investment objectives and level of risk to be taken.
Information on investments:
o details of instruments and investment strategies, risks and how clients can exit the investment.
Safeguarding information:
o how the client’s assets will be held.
Disclosure of costs and charges:
o firms must disclose the expected costs and the actual aggregated costs incurred in both monetary and percentage forms.
o These costs should show investment and ancillary costs along with how the charges will be levied and whether any additional charges or taxes (such as dealing costs and stamp duty) may arise.
o If any amounts are paid in foreign currency, then the basis of currency conversion also needs to be included.
Information about the compensation scheme and the right to complain along with information about the Financial Ombudsman service.
Most of this is usually provided in the customer agreement which will set out:
how the financial adviser will be paid, i.e. remuneration.
the service that will be provided.
the timescales involved in the provision of services.
the duration of the agreement.
the frequency of contact (usually once a year as a minimum).
The factfind is often a lengthy process, and many customers will need help to identify and articulate:
their true investment aims and what they want to achieve.
the level of risk that they are comfortable with.
the amount they want or should save / invest and for how long.
if there are any ethical considerations or restrictions based on religious beliefs.
It can extend over several meetings or telephone calls, and the adviser will need to gain the customer’s trust, not only to proceed but also to ensure that all material facts are disclosed, understood and acted upon as necessary.
Attitude to risk = subjective
Tolerance of risk = Subjective
Capacity for loss = objective
It is normal for a customer to have different attitudes to risk for different objectives.
Mental accounting is a term used for this. A customer may be prepared to accept a higher risk on say their regular savings than when investing a lump sum. Sometimes a husband and wife may hold entirely different attitudes and these both need to be considered.
12.2.5: Risk modelling
‘stochastic’ modelling tools.
Some firms use sophisticated ‘stochastic’ modelling tools. The range of possible returns from a selected asset allocation can be measured over any period of time, and a model of ‘likelihood’ can be created.
This enables them to link risk discussions directly to asset allocations.
Once the risk profile is confirmed, the investment strategy is applied using an asset allocation based on the customer’s risk profile.
12.2.4: Critical yield
What is this and how is it used to find suitable investments for the client?
This is the return that is needed in order for the client to meet their objectives.
This yield can then be used as a basis to establish the types of investments that will be needed in order to meet the client’s objectives. Of course, as before there is always a balance – if the client has a high critical yield but a low risk tolerance then it is likely that they will suffer shortfall risk i.e. the return received does not meet the critical yield.
12.3 Investment Objectives and Constraints
12.3.1: Investment objectives
There are four main types of investment objectives for private investors:
Capital Preservation
Capital Appreciation
Income
Total return
Capital preservation is for risk-averse investors who are looking for a return that keeps up with inflation.
Capital appreciation is for investors who are prepared to take higher risks over the long-term to see their capital grow. They may be saving for a specific purpose such as retirement.
Income is for investors who need to supplement their current income. Return will be in the form of dividends and interest rather than capital gains.
Total return is for those investors who are again looking for long-term growth through both capital gains and reinvesting income.
12.3 Investment Objectives and Constraints
12.3.2: Investment constraints
There are also a number of constrains that will also dictate the kind of investment strategy that needs to be used. Think of a constraint as a factor that needs to be taken into account. Time horizon, liquidity, tax, and ethical considerations are common examples of constraints.
12.3.2a: Time horizon
An investor who needs money in the short-term should probably be more focussed on capital preservation than one who is investing for the long-term who can withstand any fluctuations in the value of their portfolio.
12.3.2b: Liquidity
How quickly you need to be able to access your money is also a key consideration.
All investors should have a ‘rainy day’ fund in case of any emergency expenses so that they don’t have to sell any of their long-term investments. The starting point for any would-be investor should be an emergency fund. Keeping the equivalent of six to nine months’ expenditure in instant access accounts would be an ideal base.
12.3.2c Tax
The tax situation of the client will also play an important part when putting together an investment recommendation.
12.3.2d: Ethical considerations
Ethical Consideration to investing
For an increasing number of investors, the monetary target is not the only consideration. The rise of socially-responsible investment (SRI) is gathering pace.
These could factor in religious, ethical or moral preferences. The phrase ethical investing is probably too broad for today’s market.
Ethical funds differentiate themselves through different types of screening.
Negative Screening
Positive Screening
Neutral Approach
Negative Screening = avoid certain unethical practices e.g, avoiding firms involved in the arms trade
Positive Screening = Where there is a tolerance to unethical practise but the fund will actively seek out firms that make an effort to be ethical
Neutral Approach = Less stringent screening process to both above. Where a fund finds firms that are considered socially responsible. BY BEING STRICTLY ETHICAL IT COULD HACVE BIG IMPLICATIONS ON RETURNS
12.4: Analysing the Client’s Financial Position
12.4.1: Information gathering
First, they need to gather the necessary information, stressing to the client the importance of accuracy and completeness. Information required includes:
Identity enables the adviser to verify who the client is and to establish the source of their wealth and ownership of funds.
Age is important as it can determine the investment time horizon (an older person will have a shorter time horizon than a younger person) as well as potential capital gains tax liabilities. An older person may have been holding investments for a significant period which could give rise to large capital gains.
Health status plays a role as any serious illnesses or medical conditions could impact again on potential time horizons, objectives and attitudes to risk.
Family and dependants can also impact on investment objectives and time horizons. There may be a need to fund school fees or to pay for care for an elderly relative. There may also be divorce payments that need to be considered. Frequently when advising a married couple or civil partnership, the partners may have different attitudes to risk which need to be weighed up.
Income and expenditure – if a client is looking for a certain level of income, then the adviser clearly needs to establish the current level, so that they know how much additional income the investments will need to generate. Income levels also help establish the client’s tax position.
After an advisor gathers all relevant financial information about the client, they can produce the following:
Cashflow Statement
Net assets Statement
Tax position
Lifetime cash flow positions
Cashflow Statement =
This is a summary of a client’s income and outgoings.
Income is separated out in to earned income and investment income, fixed (salary) versus discretionary (bonuses).
It should also show tax position .
This helps establish the income that must be generated to meet income requirements .
Any excess can then be invested.
Cashflow statement is a snapshot of a point in time, but can be used as the basis for future cashflows.
Net assets Statement=
This shows the client’s net worth; similar to a company balance sheet.
It is usually separated into asset class, ownership, income yield, tax wrapper, and ethical funds.
Adviser can then see if the portfolio matches the client’s risk profile and investment objectives.
Can also show if the portfolio is overweight in any one asset class, provider or issuer.
The adviser can also see the past performance, volatility and drawdown (maximum percentage loss over the investment period) and compare them to the client’s risk profile.
Tax position =
This highlights issues surrounding income tax and CGT planning.
It checks the client’s use of pension tax reliefs, tax reliefs from VCTs, EISs and Gift Aid if income is taxed at higher rates, etc.
Transferring assets to spouses to take advantage of their tax allowances, such as using ISA wrappers and PSA / DA / CGT allowances and exemptions.
Shows whether the client’s tax status may change, such as becoming a basic rate taxpayer in the future. This helps decide when to encash investments.
Lifetime cash flow positions =
This is a personalised forecast of the client’s future cash flows.
It enables the client to see if they are able to maintain their lifestyle and meet their goals.
It also identifies when they may have any shortfalls.
So, it’s useful to project and evaluate income and expenditure during retirement.
In this chapter, we have looked at the following areas:
Providing investment advice
Advisers need to adopt a clearly-defined process that factors in customer variances.
The relationship between customer and adviser must be defined.
Trusted adviser status means the adviser needs to demonstrate technical competence and know-how, ethical conduct and empathy.
Clients must be categorised as either retail clients, professional clients or eligible counterparties.
The firm must provide clients with details of the firm and its services, the investments and investment strategies, costs and charges, and how the client’s assets will be safeguarded.
A client agreement must be drawn up so that the client has a clear understanding about the investment parameters by which the portfolio will be managed, the amount of reporting, and the frequency of reviewing the client circumstances.
Advisers must ensure that they have sufficient information about a client to give them suitable financial advice.
Advisers need to be able to understand the needs of vulnerable customers to ensure positive customer outcomes.
Client information
Advisers will undertake a factfind to establish their client’s objectives, knowledge and experience, financial situation, risk tolerance and capacity for loss.
The purpose of the factfind is to get a clear understanding of the client’s goals and expectations.
Client’s objectives should be SMART - specific, measurable, action related, realistic, time bound.
The adviser must identify the client’s main needs, and establish if these are achievable with the resources available.
A risk assessment must be undertaken to understand the client’s risk tolerance, attitude to risk, and capacity for loss.
Risk tolerance reflects how comfortable an investor is with the risk of losing money on an investment.
Attitude to risk is the high-level description of the degree of risk that is acceptable to the individual.
Capacity for loss measures how much a client can lose before it seriously impacts on their life.
The five accepted risk categories are no risk, low risk, medium risk, medium to high risk and high risk.
Critical yield measures the return that is required on investments for clients to meet their goals.
Shortfall risk is the risk that investments return less than the critical yield.
Advisers must balance the client’s objectives with their risk profile; some objectives may be unrealistic given the client’s risk tolerance and capacity for loss.
Risk modelling enables advisers to link risk discussions directly to asset allocations.
Investment objectives
The main investment objectives are capital preservation, capital appreciation, current income and total return.
Investment objectives might be expressed in general terms or specific terms.
Advisers need to consider the investor’s time horizon as that impacts on the choice of investments.
The longer the investment time horizon the greater the risk that can be borne by the portfolio.
All clients should have some level of liquidity in case they need funds to meet an emergency or to be able to take advantage of short-term investment opportunities.
Greater liquidity requirements will reduce the risk that can be taken by the portfolio.
Advisers needs to consider the tax situation of the client, as this will have an impact on the investment strategy and how they will construct the portfolio.
Ethical considerations will constrain portfolios by restricting the choice of assets.
Advisers can employ negative or positive screening to identify suitable investments.
Analysing the client’s financial information
Advisers must gather information about the client’s financial position so that they can provide a suitable recommendation.
Clients must provide information on personal details, income and expenditures, and assets and liabilities, along with any existing pension arrangements and potential inheritances.
Advisers must stress the importance that the client provides accurate and complete information so that they are able to provide suitable recommendations.
The adviser will then produce a cashflow statement, net asset statement, statement of the tax position and lifetime future cashflows to enable them to understand the client’s financial position.
The adviser needs to establish the relative importance of the client’ investment objectives, so that they understand the order of priority they should receive.
Investment recommendations
The adviser will draw up an investment policy statement that summarises the client’s objectives and timescale, the client’s risk profile, the purpose of the investments, the proposed asset allocation, and any other constraints such as ethical considerations.
The FCA also require that firms provide a suitability report to clients.
It must include the recommendation(s), the reasons behind the recommendation(s), and how they relate to a client’s objectives, knowledge and experience, attitude to risk, and capacity for loss.
