The Financial Services Authority (FSA) has published its latest Retail Conduct Risk Outlook (RCRO) report, describing the most significant retail conduct risks in the various markets it regulates.
The follows a similar report from February 2011 and is likely to be the last before the FSA becomes the FCA – Financial Conduct Authority.
As an investor, the RCRO outlook includes some noteworthy observations.
Here are what we believe to be the most important five risks identified as they might apply to investors.
Aligning business models to the fair treatment of customers
The FSA points out that many financial services firms are having to change their business models in response to current economic conditions.
This business model change can result in positive or negative outcomes for customers. For example, cost cutting to reduce expenditure can result in poorer standards of customer service.
We always urge investors to consider the motivation behind recommendations to invest. Some firms in the world of retail financial services have a better customer ethic than others.
Complexity in retail investment products and services
It is clear that the FSA is concerned about the development of some financial products which are becoming more complex. They highlight the risks associated with the complexity of traded life settlements and unregulated collective investments in particular.
The most suitable investment is usually one that is simple and easy to understand. Investors should be wary when presented with complex investments where the benefits and risks are difficult to quantify.
Structured products in particular are often complex and opaque. Whilst designed to reduce capital risk for investors who still want participation in equity market returns, they do this by transferring the risk to a counterparty, therefore introducing other risks which can be difficult to see.
Responses to regulatory change
The end of this year sees the introduction of the Retail Distribution Review. This will require all firms in retail financial services to change their business practices, in many cases by improving standards of qualifications, transparency of remuneration and robustness of research.
Whilst there are risks associated with other regulatory and legislative changes that investors should consider, we believe that the Retail Distribution Review has the biggest potential of disadvantaging some investors.
In particular, we see a risk that some advisers will use the time between now and 31st December to charge the maximum possible commission rates ahead of their retirement from financial services. Other advisers will attempt to sell their clients to consolidator firms which then offer an inferior service, but continue to pocket ongoing revenue from product charges.
All investors should ensure that their financial adviser is ready for the Retail Distribution Review today, or at the very least has a well formed plan to be ready in time for 31st December 2012. Where a financial adviser will not be ready for the Retail Distribution Review, their recommendations should be considered very carefully.
Investment propositions
The FSA highlights in their outlook report the risks associated with certain investment propositions, including the use of discretionary portfolio management and distributor influenced funds.
Before taking investment advice from any source, investors should check for the presence of a documented investment philosophy and robust investment advice process.
Where a recommendation to use a discretionary portfolio management service or distributor influenced fund is made, investors should understand the charging structure and ensure they are not paying for unnecessary layers of charges.
Systems and controls weaknesses in the network model
This risk is related to the implementation of the Retail Distribution Review on 31st December. For those investors who receive advice from a financial adviser that is part of an IFA network, they should consider a couple of issues very carefully.
Firstly, is the IFA network financially stable? Because many of these networks operate on very low margins, plenty of them are habitually loss-making and cannot offer any long-term financial stability.
Whilst this should not result in any investor loss, as client money should be held separately from firm assets, it can result in disruption and lack of continuity of service when firms inevitably go bust.
Secondly, weak systems and controls can mean that individual advisers are responsible for constructing and then delivering financial advice. We believe this is a risky approach to the delivery of financial advice and it is far better for investors when teams are involved in the research, creation and delivery of advice.
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