Brent Sheather: Advisers gamble with client funds

Many mums and dads were sold complex products that they neither needed nor understood. Photo / Thinkstock

It might feel as though New Zealand has had a monopoly in the area of poor financial advice to retail investors but many mums and dads in Britain have been badly served by their local financial advisory industry as well.

In the UK, however, the chief regulator, the Financial Services Authority (FSA), has been a lot more active in trying to control financial advisers than has been the case locally.

While the FSA and our local policeman, the FMA, have similar objectives - getting advisers to put clients' interests first - the FSA, after some missteps, has adopted quite a different strategy to that being employed here.

But first let's take a look at the most common crimes against humanity committed by the UK financial advisory industry.

Last month the FSA published a report based on a survey of the client files of 16 wealth managers - financial planners/stockbrokers providing investment advice to higher net worth individuals. These firms ranged from small independent outfits to the UK arms of global banks.

Despite thousands of pages of regulation and years of effort from the FSA, an astounding 88 per cent of the firms surveyed were giving advice that was judged by the FSA "to pose a high or medium to high risk of detriment to their customers".

Some 79 per cent of clients had received unsuitable advice and about 70 per cent had been given advice that was inconsistent with their documented attitude to risk and their investment objectives. Anarchy indeed.

Local victims of financial advisers will be familiar with many of the issues identified in the FSA survey. Chief among the failings was the "inability of the financial advisers to show that client portfolios and/or portfolio holdings were suitable".

Specifically, the survey showed that advisers:

* Didn't know their clients or ignored their clients' key details such as income requirements, assets, liabilities and, most importantly, their knowledge and experience of investment matters. It seems that many UK mums and dads got sold complex structured products with high fees that they neither needed nor understood.

* Inadequately risk-profiled their clients. Risk profiling involves establishing the risk a client is willing and able to take and making a suitable investment recommendation. This process is essential to getting a financial plan right but, as we shall see, it is extremely difficult for a financial adviser in the UK to do the right thing for the average investor needing a balanced portfolio and, at the same time, offer a competitive return after fees.

Risk profiling itself has a very chequered history - your correspondent recalls speaking to an ex-employee of a financial planning firm who said that the firm used an extensive check list to determine the risk profile of the client but then ignored the result and put everybody into the same high cost mastertrust.

An Australian study covered in this column concluded that risk profiling had limited benefits and suggested a more practical approach whereby advisers looked at what income the clients needed. Not exactly rocket science is it?

Furthermore, although risk profiling is apparently endorsed by the FMA and widely practised in New Zealand, the results appear to be being ignored.

There is much anecdotal evidence to suggest many New Zealand investors have portfolios that are underweight in bonds relative to the position of the average pension fund.

I have seen three portfolios in the past two weeks where retired investors have been paying annual monitoring fees of about 1.5 per cent and, perhaps not coincidentally, had bond weightings of between zero and 10 per cent.

For some perspective on the suitability of this asset allocation profile, consider that the average pension fund, which caters to investors with an average age of 30 to 40, has for the past 30 years or so had a 40 per cent weighting in bonds.

This poor advice in the UK should come as a surprise to no one and it is much the same deal here. This column has long argued that if a financial adviser charges high annual fees, as almost all do, the investment plans they formulate will be unable to sustain much in the way of genuinely low risk assets.

For example, in the UK 10-year government bonds, an essential component of any diversified portfolio and part of virtually every institutional balanced managed fund, yield just 3.4 per cent. But the average annual management fee charged by UK wealth managers on the first £1 million, according to a recent survey in the London Financial Times, is around 1 per cent and ranges from 0.6 per cent to 2 per cent.

To this figure must be added platform fees, transaction fees and, more often than not, the management fee of the fund used to achieve exposure to the fixed-interest sector. These charges total 2-3 per cent a year, and financial advisers know that most of their high net worth clients can do the maths - that is, 3.4-3.0=0.4 per cent.

No surprises, then, that in the UK, like New Zealand, genuinely low-risk bonds, which are the perfect complement to an equity portfolio, as they go up when equities fall, are substantially underweight in most portfolios - the FT survey found that the average balanced portfolio had more money in hedge funds than government bonds.

One balanced portfolio had an astounding 83 per cent invested in shares, and that excluded its exposure to commodities, hedge funds and private equity.

Rather than buy government bonds, financial advisers tend to opt for high-yield bonds, many of which unfortunately change their spots when the proverbial hits the fan and start to behave like shares, falling in value as the prospect of recession and default loom large. From a diversification perspective high-yield bonds are a bit like umbrellas that are available for use at any time except when it starts raining.

So that's an outline of the scope of the problem in the UK and New Zealand: interest rates are low and prospective returns from shares are just 6-8 per cent, but annual fees remain high at 2-3 per cent a year, effectively forcing advisers to gamble with clients' retirement and by being overweight in risky assets like shares in the hope that a bull market will sustain the high fee structures.

In Europe and the US, regulatory authorities are stress-testing the banks to ensure that they can cope with an adverse environment. Perhaps we should be stress-testing retail investment portfolios as well.

As we shall see in two weeks, the UK regulatory authority, the FSA, now appears to be on the right track and has formulated a quite radical solution to the problem.

However, a similar low-return/high-fee environment also plagues New Zealand retail investors, so we will also look at how New Zealand's investment policeman, the FMA, proposes to deal with the situation.

* Brent Sheather is an Auckland-based authorised financial adviser and his adviser/disclosure statement is available on request and free of charge.