In the past, an adviser to a family office would operate primarily on the instructions and guidance of the senior family member. However, this has not always proved appropriate for all members of the family, with the unmet investment needs of some individuals causing wider family disharmony. The financial crisis and recovery has provided an opportunity for reflection: to understand what went wrong, how regulations and working practices can be improved to prevent history repeating itself. One such hot topic is suitability and in March 2011 the FSA published its final guidance on this topic. Although the subject is likely to evolve, the FSA’s findings are certain to cause family offices to review the way in which they operate.
One of the most important aspects of assessing the suitability of an investment, given the subjective nature of the topic, is assessing each client’s attitude to risk.
As its report has identified, the FSA has three key areas of concern: that a client’s risk profile is not being assessed correctly; that the client may not have a full understanding of the consequences of the level of risk to which they will be exposed; and, once assessed, that risk is not being expressed appropriately in the portfolio management.
The FSA rightly does not seek to prescribe how firms should establish the risk a customer is willing and able to take or what investment decisions should result from such discussions. As the report makes clear, a mechanical ‘box ticking’ approach is insufficient on its own and a better way is an open and continuous dialogue with the client. A structured approach to this
is useful to promote a greater consistency of outcomes but there is no substitute for good communication. Therefore, investment advisers need to make the most of the communication channels inherent in the family office.
Personal circumstances do not stand still and changing situations, such as an unexpected death, redundancy or divorce – to say nothing of windfalls, such as the sale of
a family business – are obvious moments to take stock and adjust an investment approach if appropriate. Besides, investment markets change and develop at such a pace that there is a clear need for continuous assessment rather than simply treating suitability testing as a one-off exercise.
In cases where wealth stems from an individual’s historic position or financial skill, it is understandable that they have had significant influence over the wider family’s interest. However, changes in regulations and legal duties, such as those contained within the Trustee Act 2000, have prompted advisers to review the way they operate. When the patriarch is also the manager of the family’s wealth, the conflicts of interest are legion but untangling these conflicts needs to be handled sensitively. With any kind of distance it is self-evident different individuals and entities within a family grouping have different needs. Although clients have always been individually assessed, the FSA’s report has underscored the importance of this. While a single family multi-asset investment vehicle may bring tax and administrative benefits, a diverse family may not find the ‘one size fits all’ vehicle is appropriate.
There is also an increasing desire for all family members to have a greater awareness of their financial situation in order ensure the continuity of the family’s wealth. Therefore, it is the investment manager’s responsibility to understand the needs of each individual and group within the broader family and recommend a suitable bespoke approach. Having a meaningful understanding of tax and trust issues involved is essential in providing the family with a better service. Indeed, a major benefit to the family office is where tax and investment advisers have a strong working relationship so as to maintain the most suitable balance of investments.
It is only once the adviser has a clear understanding of the risk parameters of the various members of a family that a suitable investment portfolio can evolve. Failure of investment advisers to meet a client’s risk level was the cause in about half the files assessed as unsuitable in the FSA’s review of the investment advice and management industry over the two and
a half years to September 2010. Clearly, portfolio construction is a subjective matter and one best left as a separate discussion, though sensible investment diversification will be core to a suitable portfolio.
When looking at suitability one needs to concentrate on risk - and when we say risk, we really mean downside risks since few clients complain about the upside. Too often, volatility is used as a sole measure of risk. As the financial crisis has unfolded over the last few years, it has become clear that there are many risks surrounding investment. These range from the systemic to the specific, from credit and counterparty risk to liquidity, not to mention concentration or inflation, which is likely to become an increasing risk in the years ahead. Assessing a client’s capacity for loss, noting that it may change over time, is a vital component of the investment strategy.
It is evident that the family office adviser should develop a deep understanding of the myriad client needs and how these needs relate to the wider family. There is also the need to communicate regularly with each of the family members and their Trustees, not only to help them understand the investment risks to which they are exposed, but also to hear from clients on their changing views and circumstances. It is only with this knowledge that the right level of suitability can be achieved. In other words, good old fashioned ‘Know Your Client’ – so perhaps, after all, traditional values can survive the rigours of the modern era.
