One of the biggest hopes for ensuring that we don't have a repeat of the finance company debenture mis-selling fiasco is that advisors have to abide by a Code of Conduct (the Code).

Arguably the most important standard is Code Standard 8 which says that "an authorised financial Advisor must take reasonable steps to ensure that the service he/she provides is suitable for the client".

Suitability is to be based on information provided by the client, including the standard things like financial situation, needs, goals, tolerance for risk blah blah blah.

Whilst this sounds good whether it will actually make a difference depends on how you define suitable, how far you want to take suitability and most importantly whether those who make judgment on suitability actually know what "suitable" looks like.

The most obvious determinant of suitability in a financial plan is of course asset allocation and an unsuitable plan might be where someone with a low risk profile is told to invest totally in shares.

That's obvious. But today it is quite easy to put together a portfolio which a reasonable person would deem unsuitable whilst still getting the asset allocation right. Furthermore it is not at all clear whether too many people know, or want to know for that matter, what best practice looks like.

Two weeks ago we contrasted best practice as evidenced by the investment portfolio of institutional investors with anecdotal evidence as to what retail portfolios looked like. To really make a difference we need to define suitability as being portfolios which are consistent with best practice amongst professional investors and, most importantly, which will fulfil the objectives of the client.

It's unclear whether the powers that be, let alone the industry, has the appetite for this or even has an appreciation of what best practice looks like. Certainly current fee structures, in the context of realistic return forecasts are a huge obstacle to fulfilling client objectives.

As we pointed out it is pretty clear that best practice as per pension fund portfolios is frequently at variance with the standard business model of many stockbrokers and financial advisers. Three examples will illustrate. Firstly, the average annual fee structure of the big financial planning firms is 2-3 per cent pa.

So this means that government bonds which typically make up the bulk of a pension funds fixed interest portfolio are off the menu because yields on government bonds are barely 3 per cent and financial advisers know that sooner or later clients will do the math and realize that 3 - 2 doesn't leave much for them so that often means junky debt which starts acting like a share at the first sign of trouble. Another way that the standard business model precludes best practice is as regards new issues.

The Feltex offer was instructive because what happened then, as happens with the IPO's today, is that when brokers got their allocation of Feltex they contacted their clients and recommended they buy the stock without having too much regard for Feltex's relative size in the stockmarket.
Simplifying things, Feltex never represented much more than 1 per cent of the NZ stockmarket yet anecdotal evidence suggests many retail investors had 5 per cent, 10 per cent or 15 per cent or more of their NZ share portfolios in Feltex.

Any fund manager with a 10x overweight position in a stock would get a stern warning from the trustees pretty quickly. This sad state of affairs comes about because many stockbrokers have corporate departments who get paid to sell a company's shares to their clients, thus they are conflicted because they work for two parties with different objectives.

Thirdly most estimates of the forward looking equity risk premium of equities over long term bonds are around 3 per cent so an investment proposition with a 3 per cent total annual fee structure effectively offers retail investors the return of bonds with the risk of equities. Again, it's hard to see this as suitable is it? These are just some of the structural issues in the industry that make "suitability" problematic if not impossible.

Financial planning website, Financialalert, carried a story the other day on how various experts thought suitable advice might be defined. Simon Hassan, a financial advisor who is on the disciplinary committee for financial advisors was of the opinion that one key test of suitability was whether other financial advisors would think a plan was appropriate. This so called "peer test" is apparently particularly important and according to one commentator it was referred to in a recent court case involving a financial advisor.

Whilst a "peer test" might make intuitive sense that presupposes that the industry, as a whole, is doing the right thing but that may not always be the case.

For example, a few years back, just about every financial plan I saw recommended finance company debentures as the fixed interest portfolio. So on this basis no one was doing anything wrong because everybody was recommending finance company debentures. Ridiculous logic. Today many financial advisors and stockbrokers recommend that investors attain their exposure to NZ and Australian stock by buying 5-10 stocks in each market.

This sort of concentrated portfolio is a recipe for disaster and hugely different to what best practice looks like as evidenced by the portfolio of professional investors. A cynic might suggest the "peer test" provides useful information the extent that if other financial advisors think a plan is appropriate then it most likely isn't. There are more examples of why the peer test is ridiculous than we have space for here but some others that have made this column include the following:

• In the Rodney Hartles case a while back we had one of the "experts" make the ridiculous comment that "a reasonable financial advisor" would have invested 10 per cent of a client's total funds in finance company debentures. That's almost half the bond portfolio in junk. Heaven help us.

• An AFA wrote in the newspaper recently that his clients had no bonds in their portfolios because interest rates were low.

• A financial advisor when putting together financial plans assumed historic returns from the stockmarket would continue when research clearly shows that it wishful thinking.

• Another financial plan described itself as adopting an 'absolute return strategy' yet didn't use any absolute return products.

To get to truly suitable advice we need some fresh thinking including the following;

• abolish commission,

• the FMA to broadly define good advice, publicise examples of bad advice widely with names and prosecute the worst offenders,

• the FMA to adopt a more prescriptive regulatory regime as per the FSA in the United Kingdom, where for example, when you make a forecast of returns in a financial plan you cannot choose the highest number you can think of. It has to be realistic,

• Universities to be put in charge of training of AFA's and make sure they teach best practice, not bad practice. Make sure they are not "captured" by the industry as has happened with the "Code", AFA qualifications and CPD.