Artful advice

(October 2006) If you believe the premise that compliance starts with the advisor, then it’s the firm’s duty to ensure that advisor has the tools necessary to help clients understand what they’re getting themselves into.

Investments are complex. So, even if your clients tell you they understand things like risk and the theories behind portfolio performance, it still falls to advisors to make sure that’s true. It’s not that clients lie, but many are embarrassed to be perceived as ignorant and may try to sound more sophisticated than they in fact are.

The average investor doesn’t understand modern portfolio theory. They don’t understand correlation, or why low correlation is good in a portfolio. So you need to make sure you have what it takes to convey the meat of those concepts without boring the client to the point where he or she stops listening.

How many times have you heard an advisor complain about a client who acted like he knew his stuff and seemed gung-ho about an aggressive, high-risk investment strategy but then quickly wrote a complaint letter when the markets took a turn? It’s an old story, and the only way to stop it from being told is for advisors to accept it’s their job to make sure a client really does understand the risk being taken on.

Advisors have to ask the right questions; understand what a client’s monthly financial commitments are; and determine what other expenses they may have (alimony to an ex-spouse, or a parent in a nursing home). People don’t always offer that information on the first visit. Really getting to know the client takes time but it needs to happen before the portfolio is designed.

Once you understand their needs, find out how much they know about how the markets work and fill in any blanks. One way to do that is by using graphs that show how much risk a client is taking on with a particular stock, mutual fund, or even a basket of securities or funds.

“Investors want to see graphical representations of risk, return and MER. And it has to happen between the advisor and the client face to face,” says Edward Iftody, president of PureLogix in Vancouver. “There are too many cases where a Know Your Client form is filled out, the trades are placed, and then compliance comes back and says, ‘There isn’t enough risk in the compliance form. Get it changed.’ ”

In such cases, the client is put in a position whereby he or she has to change the risk profile on the KYC, or risk having the account frozen. Too often, says Iftody, those changes are made for expedience rather than because it’s the right thing for the client. His company addresses that problem through a software system that can display the risk level of a portfolio, and even a series of risk scenarios.

He notes this is especially useful when clients are using more than one mutual fund, because it allows a client to look at the risk level and determine if it can be lived with. The portfolio can be tweaked until advisor and client reach consensus. Then, the KYC form is filled out, signed and goes through compliance without delay.

Graphs or no, Al Nagy, an advisor with Investors Group in Edmonton, says it’s the advisor’s job to make sure the client understands risk. “If they’re not paying attention, it’s my fault,” he says. “I have to make sure they grasp what I’m saying.”

He uses graphs if he thinks they’ll help a client understand one financial instrument is riskier than another. Often, he’ll draw the illustrations himself as he goes along – but adds that even clients who are engineers often aren’t interested in seeing charts about standard deviation and correlation. They expect him to understand those concepts, he says, but prefer more jargon-free explanations. “They say, ‘Okay you know your stuff. Just tell me if it’s risky or not,’ ” he says.

Iftody agrees graphs should be straightforward and advocates they be used to show a client where a portfolio stands, and where it’s going. One way they’re particularly helpful is to convey how much value a particular security, or group of securities, has lost historically; knowing that can help a client understand worst-case scenarios and make rational decisions about risk.

If you do use graphs, use them wisely and accurately. Back in the 1990s, a lot of mutual fund managers tried to boost perceptions of their own brilliance by showing the“past” performance of the funds they’d only just put on the market. The managers actually tracked performance that would have taken place – had the fund existed –going back several years. Of course, they often packed those funds with stocks that had done zoomingly well, so the “past performance” made the brand new funds look like can’t lose propositions.

As the ’90s ended and reality set in, regulators zeroed in on that practice and passed a series of regulations prohibiting it. Performance had to be tracked from the day the fund was first made available. Not before. And every chart showing the progress of the fund had to contain a disclaimer indicating past performance could not be taken as an indicator of future results. Furthermore, private funds going public could not use old performance data. The fund’s history had to begin on the day it became available to public investors.

Borden Ladner Gervais partner Rebecca Cowdery notes guidance, articulated in National Instrument 81-102, wasn’t so much new rule making, but rather a odification of existing expectations. That’s an interesting take.

In the U.S., regulators produced a set of punitive regulations related to performance figures and sharply tightened reviews of advertising materials. In Canada, the regulators reiterated their expectations. A lot of trust is being extended to your firm. Use it well, and make sure you tell the truth, by the numbers.