AFA 1 Investment 2024 Topic 14 PDF

Topic 14 Advice Learning objectives After studying this topic, you will be able to demonstrate an understanding of the main factors an adviser needs to consider in order to meet the FCA’s ‘know your client’ requirements and ensure that clients are given suitable advice. These factors...

Topic 14 Advice Learning objectives After studying this topic, you will be able to demonstrate an understanding of the main factors an adviser needs to consider in order to meet the FCA’s ‘know your client’ requirements and ensure that clients are given suitable advice. These factors include: ‹ the client’s attitude to risk; ‹ the client’s objectives; ‹ the client’s current and future financial circumstances; ‹ the timescale; ‹ the amount; ‹ diversification and balance; ‹ asset allocation; ‹ the client’s tax position; ‹ the client’s attitude to socially responsible investment; ‹ ongoing reviews. 14.1 Introduction It is a basic principle of FCA regulation that financial advice should be based on a thorough knowledge of all relevant information about the client that might affect that advice. It is also a requirement that the adviser should act in accordance with the FCA regulator’s principles, in particular to treat the client fairly and at all times act in their best interests. It is also important to understand that the investment needs of the individual will change throughout life. In early life, people may wish to save out of income in order to create capital, while in later life they may wish to invest capital for the creation of income. We investigate this issue in section 14.2.3. The main focus of this topic is the full investment advice process that advisers should follow. However, we need to mention the introduction of ‘robo‑advice’ (automated advice based on algorithms) as part of the FCA’s Project Innovate, whereby investment advice can be offered in a different way to help new entrants to the market and to encourage innovation. ©LIBF Limited 2024. All rights reserved. 387 14: Advice Robo‑advice is an initiative designed to enable advisers to satisfy the basic advice needs of clients who cannot afford standard fees, and to increase the number of clients they can deal with compared to the ‘normal’ regulatory advice process. Based on a consumer’s answers to an online questionnaire, the robo‑advice programme recommends a portfolio or product that is suitable for their needs and can be totally automated or used in conjunction with human support. The FCA has proposed an increase in the amount of robo‑advice freely available online, and urged banks and other financial institutions to improve their efforts in informing their customers. The number of offerings is growing, with Nutmeg perhaps being the best known. 14.2 Factors to consider In order to demonstrate compliance with the ‘know your client’ requirements when advising on investment, the adviser must establish specific information about a client’s situation, investment attitudes and objectives, as summarised in Figure 14.1. In some cases, the information will be additional to that collected in a normal factfind. Figure 14.1 ‘Know your client’: issues to consider 14.2.1 The client’s attitude to risk The client’s attitude to risk – or risk profile – is a primary consideration when making investment recommendations. The ‘know your client’ rules specifically require the adviser to take all reasonable steps to ensure that the client understands the nature of any risks implicit in the recommendation. This means they will have to take great care to establish the client’s objectives and attitude to risk before making the recommendation. This is particularly important when advising on investments, and it is important to establish the client’s attitude to risk, both generally and towards the specific investment under consideration. A client who already holds other investments might be prepared to accept a greater degree of risk with their new investment. A client who has no other capital, on the other hand, is likely to prefer a more safety‑conscious approach. All of this means explaining the relationship between risk and reward, and identifying the client’s feelings about the 388 ©LIBF Limited 2024. All rights reserved.  14.2 Factors to consider capital – are they prepared to take a degree of risk to achieve their target, or is safety the most important factor for them? The client’s attitude to risk could also vary from objective to objective – retirement, school fees and so on. General considerations would include the following. ‹ Does the client want income or capital growth? ‹ How much of their available capital do they wish to invest and how much should be left in easy access accounts for other needs? ‹ What is the client’s attitude towards tying money up for the medium to long term versus having access to it in the short term? ‹ In the case of income, does the client want the income now or at a point in the future? Can the client accept a fluctuating income? ‹ Is there a specific timescale and purpose for the investment? How important is it to achieve the objective? Sensible investors will want to make the most gain from their investments while taking the lowest risk. The adviser’s role is to find out what they want the investments to achieve and then the level of risk they are prepared to take to achieve those objectives. We looked at risk versus reward in Topic 7, and it is clear that, in most cases, the client will only achieve objectives by taking a degree of risk. There are two main factors in the equation. ‹ The client’s objectives and how much money is available to meet them – if the client has sufficient resources it may be possible to achieve their objectives without taking any risks, although that is unlikely. For example, if the client wished to provide a lump sum of £50,000 in ten years’ time, they would need to invest £33,778 in a deposit account earning interest of 4 per cent pa (ignoring tax). This would provide a virtually no‑risk investment, providing the interest rate averaged 4 per cent over the term, which is not unrealistic given that interest rates do not vary widely in a stable economy. In contrast, a share‑based investment growing at 8 per cent pa would require an initial sum of £23,160 to achieve the target, although performance is likely to be more volatile, less reliable and possibly outside the client’s ‘comfort zone’. ‹ The degree of risk the client is prepared to take, considered objectively and subjectively – in the example above, unless the client has the initial capital to fund the deposit option, they will probably accept that, considered objectively, the share option is the logical route. However, on an emotional level, they may be reluctant to take the required level of risk with their money. The client will therefore have to weigh the probability of missing the target by taking a safe approach against the possibility of reaching the target but risking their capital by taking the more adventurous option. The key is to balance the objectives against the risk the client is prepared to take. It is also important to realise that a couple may each have a different attitude to risk; this needs to be taken into account when formulating advice. Client attitudes to risk can be broadly categorised as follows. ‹ No risk/risk averse – not prepared to take any risk at all. ‹ Low risk/cautious – may be prepared to take a very small element of risk if convinced that it is necessary. ‹ Medium risk/balanced – accepts that some risk may be necessary with some of their available money but would prefer any risk to be controlled. ‹ Medium to high risk – relatively happy to gamble with a larger part of their capital if the potential reward is attractive, and to accept losses as part of the bigger picture. ©LIBF Limited 2024. All rights reserved. 389 14: Advice ‹ High risk/adventurous/speculative – prepared to take a high level of risk in order to achieve growth. Some firms use fewer categories, while others extend the categories further. It is very likely that the client’s investment experience will be reflected in their attitude to risk; the more experience of investment, the more adventurous the investor. 14.2.1.1 Capacity for loss An essential part of the overall assessment of a client’s attitude to risk is their capacity for loss. The two factors are subtly different, but go together when considering suitability. Capacity for loss boils down to a simple factor: if the potential risks of the investment became reality, and some or all of the invested money was lost, would it have a detrimental effect on the client’s life and living standards? In other words, can they afford to lose the money? Factors to consider would include the following: ‹ Existing debts – any potential loss would have a greater effect on a client with existing debt. ‹ Future capital needs or obligations – if the client has a need for capital at some future point, has made promises, or entered into legal agreements to provide cash or funding, losing cash through an investment may result in threats to those plans or promises. ‹ The nearer a client gets to retirement, the lower their capacity for loss would usually be because there is less time to recover losses. ‹ It is also important to ensure discussion with the client to make sure they understand exactly all the considerations involved in determining capacity for loss, as opposed to their attitude to risk. 14.2.1.2 Establishing the client’s attitude to risk When establishing the client’s attitude to risk, it is likely that the adviser will need to explain the types of risk to ensure that the client makes an informed decision. In general, the types of risk would be: ‹ the risk to capital; ‹ the risk to income produced; ‹ the way in which different investments work and the risk involved – deposits versus shares, for example; ‹ the effect of time on an investment – secure investment is sensible for short‑term investment, while asset‑backed investment (based on stocks and shares) is prudent for medium‑ to long‑term investment; ‹ the risk of not achieving the objective by being too cautious or too adventurous; ‹ the risk involved in shares or single investments, compared with pooled investment. There are a number of ways to establish the client’s attitude to risk. 390 ©LIBF Limited 2024. All rights reserved.  14.2 Factors to consider 14.2.1.2.1 The interview approach The adviser asks the client a number of questions about their feelings towards their money and the risk of losing some or all of it. Questions would include: ‹ What investments does the client already have (or has the client had in the past)? ‹ How does the client feel about those investments? ‹ How have they performed? ‹ Is there anything that concerns the client about those investments? ‹ How would they feel if the value of their investment went down? ‹ How do they feel about the risk–reward relationship? ‹ How important is security of capital? ‹ How would they feel if their investment missed the target? ‹ What level of understanding do they have about the different investment vehicles? The answers to these questions will allow the adviser to draw an informed but unscientific conclusion about the client’s attitude to risk, in conjunction with the client’s objectives and the timescale. In the past this was the standard process for most advisers, but it is flawed because the result will always be very subjective and reliant on the quality of the questions, the adviser’s explanations and the client’s understanding of the process and the questions. 14.2.1.2.2 The menu approach The adviser describes the categories of risk tolerance and then asks the client where they feel they fit in. As with the interview approach, the result is heavily dependent on the skill of the adviser and the client’s understanding of the categories. The adviser may, unwittingly, influence the client through intonation or emphasis, or the client may be eager to answer in the way they think the adviser would expect or like. 14.2.1.2.3 The psychometric approach The adviser uses tools to assess the client’s psychological attitude to risk in general rather than their objective ability to cope with financial risk. Psychometrics assesses the client’s knowledge, experience, attitudes and personality rather than considering how much they are prepared to risk. The tests are validated statistically by using a large sample of the population. The questions will consider a number of aspects of the client’s approach, including: ‹ their own feelings on their attitude to, and tolerance of, risk; ‹ past financial decisions they have made; ‹ how they would feel and react in a number of ‘what if?’ financial scenarios containing positive and negative outcomes; ‹ how they would feel about a number of hypothetical events and outcomes in relation to their finances. ©LIBF Limited 2024. All rights reserved. 391 14: Advice 14.2.1.2.4 The portfolio approach The adviser shows the client a number of hypothetical portfolios, each comprising different ratios of investments described merely as low risk, low return; medium risk, medium return; and high risk, high return, together with examples of investments that would be in each category. The client’s chosen portfolio provides an indication of their attitude to risk and will provide a basis on which the adviser can plan asset allocation. It is common to categorise a client’s attitude to investment risk by using the following descriptions: ‹ risk averse; ‹ low risk; ‹ medium risk; ‹ high risk (speculative). 14.2.2 The client’s objectives The client’s objectives will be a significant factor in deciding the level of risk they are prepared to take. If the objective of the investment is very specific, the client will want to know that their target will be met. An example of this is loan repayment – for which the client will need the investment to pay off the loan on the due date. Another example may be school fees planning, for which fixed amounts are required at specific times. If the client has few other resources to call upon, they will want to be sure the funds will be available when needed. This will lead to a more conservative approach to the investments selected. In the case of a longer‑term objective, even where meeting the target is imperative, it may be possible to take a more speculative approach in the initial stages, with a view to transferring some, or all, of the value into lower‑risk investments nearer the end of the term. This will consolidate the gains made to that date and provide a greater degree of security when the funds are required. Where the main objective is to provide income, the investor is likely to choose investments that produce a relatively high level of interest or dividend income. This might mean that capital growth is sacrificed to some extent; this is a form of risk in itself. The client should be aware that low capital growth might reduce the real value of the income in future years. If the investment is not for a specific purpose, then security may be less important to the client and more speculative investments can be considered, if they have other funds that are sufficient to compensate for any loss. Clients will often have a number of objectives, some of which might need different types of investment. In this situation, the client should first prioritise the objectives to establish which is most important. Action can then be taken to secure these as far as possible. The adviser should ensure that the client has realistic expectations regarding their objectives. ‹ Do they have enough to invest now to meet their objectives? ‹ If not, which objectives are they prepared to compromise on by reducing the target or extending the timescale? ‹ What would happen if they were not to meet some of the objectives? ‹ Are there other ways in which the objectives might be met – reorganising current arrangements, and so on? Where a client has a range of objectives, each with a different priority and timescale, it is not unusual for the client to have a different attitude to risk for each of these objectives. 392 ©LIBF Limited 2024. All rights reserved.  14.2 Factors to consider 14.2.3 Age and the life cycle The client’s needs, objectives and attitude to risk will be affected by the life stage at which they find themselves. Those who are in the early stages of working life may have little disposable income from which to fund investment or savings. If they feel a need to invest at all, it is likely to be to save for a house or to build an emergency fund. Both of these objectives are best served by low‑risk investments. Becoming a couple brings with it a number of financial challenges. There may be two incomes, but there is also likely to be a desire to build a deposit for house purchase and/ or to put money aside for future needs, particularly children. If the couple manage to buy a house, their disposable income will be stretched and investment will take a low priority. For this reason, much of the investment focus will be on low‑risk investments, providing easy access and capital security. If children arrive, it is more likely that the couple will be dipping into savings, rather than putting money aside for the future. Any cash they do manage to save is likely to be kept on deposit for emergencies and short‑term needs. Middle age often sees clients at their most affluent: they have more disposable income and are more disposed towards saving. They may even have built up some capital. In today’s society, with home ownership common and property prices having escalated, it is those in their 50s who are the largest recipients of inherited wealth; much of this wealth will be invested. Those in middle age can often afford to take a medium‑ to long‑term approach to saving and are likely to be interested in building up capital and income for retirement. This means that they will consider investing in vehicles that offer the prospect of capital growth but increased risk. Those in retirement are unlikely to be able to invest from their income; in fact, it is likely that they will use existing investments to supplement their retirement income. This means that they may move existing investments to provide income and that they will wish to protect their capital to ensure a continuing income. The retired investor is likely to select low‑ to medium‑risk investments to achieve this goal. The introduction of pension freedoms has led to many retirees opting for drawdown which represents, and requires, a higher risk approach. While these typical planning concerns across the life cycle provide a useful guide, it does not remove the requirement for an adviser to examine closely the investment needs of any particular individual. There are many people whose lives do not fit this pattern and they may have significantly different investment needs. 14.2.4 The client’s current and future financial circumstances In considering how best to achieve a client’s investment objectives, it is essential to look first at their present position. This will indicate how much capital or income the client has available to start or continue saving and investing. It will also indicate what other, more pressing, needs they might have – needs that might impact on their ability to invest. For example, it would not be good advice to make investment recommendations to parents with insufficient life cover – protecting the family is a more important issue than investing for the future. Key questions for consideration are outlined below. ‹ Has the adviser established a full picture of the client’s circumstances? A client investing £5,000 can adopt a much more adventurous approach if this sum is a fraction of their total wealth rather than its whole. They might, however, have forthcoming events that require capital outlay and, for these reasons, it is important to get a full picture of the client’s circumstances. ©LIBF Limited 2024. All rights reserved. 393 14: Advice In general, the more the client is likely to need access to the money, the lower the risk that should be taken. It is not wise to tie up money that may be needed at short notice in equities or other longer‑term investments: it may be difficult to release the money at short notice or it may be necessary to cash in at the ‘wrong time’. A common piece of advice is that one should only invest in shares and similar vehicles with money that one is prepared to lose, or at least see reduce in value. The principle of pooled investment means that this view may now be seen as rather extreme but, nevertheless, it is a useful cautionary note. ‹ Is there scope for the client to reduce their outgoings? It may be that a client’s financial affairs are not arranged to their best advantage. For example, the client may have expensive borrowing that might be refinanced at a reduced cost. Similarly, clients may not be claiming all of the tax allowances to which they are entitled. In both instances, it may be possible to reduce the client’s outgoings and so increase the amount available for investment. It is clearly important that the client is able to afford the investment that is recommended. ‹ Are the client’s current investments achieving their objectives? Investments held by the client need to be reviewed from time to time. This will establish whether they are achieving their purpose and whether they can be rearranged to the client’s benefit. An example of this would be where a client has a substantial amount invested in a building society account: with growth over time, it might be more advantageous for the client to invest some of the money in an investment offering capital growth. ‹ Are the client’s investments tax efficient? It may be that the client’s investments are providing income that is not needed and which could be subject to higher‑rate income tax. Reinvesting in other investment vehicles may increase tax efficiency. ‹ Are the client’s investment arrangements flexible enough to take account of changing future needs? When reviewing a client’s existing situation, whether dealing with assets, liabilities, income or outgoings, decisions cannot be based only on the current situation. Whatever that situation, it is likely that the client will have a view of what they want for their financial future. Again, this will vary from individual to individual, both in content and timescale. The client’s anticipated future needs will naturally be linked to specific objectives: to have children, to retire early or to move abroad are examples. Changes to a client’s circumstances may impact on investment recommendations made earlier. A client may be able to afford a given level of regular investment at the moment, but what if they are planning to start a family? Children place a heavy burden on financial resources and, if a particular investment plan is not flexible enough to accept reduced contributions, it may lapse. This will cost the client money they can ill afford. It is obviously not possible to cater for every eventuality, but the client will want to maintain flexibility within any investment strategy in order to cater for the changes they think may be likely. 394 ©LIBF Limited 2024. All rights reserved.  14.2 Factors to consider ‹ Would the client be better off repaying debts rather than investing? For example, if the client has a mortgage of £100,000 at an interest rate of 4 per cent and is a basic‑rate taxpayer, at the end of the fifth year they will be paying: £527 a month in total, of which: — £290 would be interest; — £237 would be capital. Given that the mortgage will be paid from income subject to tax and national insurance, they will have to earn £426 to pay the mortgage interest. Assume for a moment they have £20,000 to invest. If they were to repay £20,000 of the mortgage but keep their monthly payments the same, they would reduce their monthly interest payment to £223 (reducing further each month) and would pay off their mortgage after a further 13 years and nine months (just over six years early), saving interest of £19,200 over the term. Alternatively, they could keep the original term but reduce their monthly payment to £405 a month. If they invested the £20,000 in a deposit account instead, they would need to receive a better return from any proposed investment than the amount by which they reduced their payments; in this case, around 7 per cent gross. Compared to using the capital to reduce the monthly mortgage payments, or maintain the payments to reduce the term, their savings would need to produce a consistent return well in excess of 7 per cent. Given that interest rates for saving are well below those for mortgages, they will have to consider a higher‑risk investment, such as equities. Even then, they may struggle to achieve the goal due to the volatility of such an approach, and the risk involved may be unacceptable. In this case, serious consideration should be given to debt repayment before investing. 14.2.5 The timescale The period of the investment will influence the level of risk that a client will be prepared to take and the amount of funding required today or over the term. Some investments fluctuate in value in the short term. Over the longer term, however, they may experience good growth. This sort of investment can be considered as higher risk in the short term, especially if the client may need access to funds at short notice. In the longer term, fluctuations may not be seen as such a problem, particularly if the client has some control over when the money is needed. Where the objective is short term, deposit‑based investment is almost always the most prudent approach. The capital is needed in a relatively short time and it is not wise to invest in equity‑based vehicles: there would be a danger that the capital value could be reduced over the short term. Security of capital is important because there will be little time to make up any losses. Where the objective is medium to long term, the investor might consider asset‑backed investment – but only where they are confident that a reduction in capital will not be a major blow. Those considering equity‑based investments are advised to allow a minimum investment period of five to seven years in order to allow the capital to ride out fluctuations in value. Even then, there is a risk that the investment may either not have grown or may have reduced in value. Clearly, the longer the time span until the investment is needed, the more likely that asset‑backed investment will be suitable. ©LIBF Limited 2024. All rights reserved. 395 14: Advice 14.2.6 The amount The amount to be invested is another consideration: if it forms a small part of a larger ‘fortune’, the investor might well be prepared to take some risk; if it is their only capital, they will be more defensive. In the same way, if the client has a larger amount to invest, it can be spread across a wide range of asset types, some of which can be more speculative. The other factor is the amount of growth that the available amount will need to achieve in order to meet the objective. If the available amount is small and the target is aggressive, it will be necessary to take a more speculative approach, or for the client to re‑evaluate their objective. It is a basic principle of investment planning that the client should maintain an emergency fund in liquid form, such as a bank account or easy access savings account. There is no definitive benchmark as such, the most common approaches being that the fund should contain: ‹ three to six months’ income; or ‹ three to six months’ regular expenditure; or ‹ 10 per cent of the client’s total capital, subject to a minimum of a few months’ expenditure. 14.2.7 The client’s tax position Taxation can have a significant effect on investment decisions. It is necessary to look at the client’s current tax position and the potential future tax position. If the investment is designed to produce income, this may increase the amount of income tax payable by the client. It may be more tax efficient to invest for the production of capital where capital gains tax allowances are not being used. Alternatively, it may be possible to arrange or transfer the investment into a tax‑free vehicle. Tax legislation can change from year to year and so it is important to realise that decisions should be taken based on what is known, rather than what is rumoured or thought to be possible. 14.2.8 The client’s attitude to sustainable investment Investors may have a preference to invest in a sustainable manner, taking into account environmental, social or governance factors. For instance, ethical or socially responsible investments allow investors to ensure that their money is channelled to companies and organisations that match their own values and beliefs. Many investors would choose not to invest in tobacco‑related industries or those countries where workers are exploited. Similarly, investors may have a preference to invest in a manner that addresses environmental concerns such as climate change. When advising an investor, it is clearly important to ensure that their attitudes and beliefs are investigated before recommendations are made (see section 14.3). 14.2.9 Ongoing reviews Investment should not be seen as a one‑off event. Markets and products change, the investor’s needs and attitudes will alter over time and the initial investments may no longer fit the 396 ©LIBF Limited 2024. All rights reserved.  14.2 Factors to consider circumstances. It is important for adviser and client to agree regular reviews of the portfolio to ensure all of the variables are considered and the portfolio adapted where necessary. Unfortunately, most investors who do think about the allocation of assets in their portfolio fail to review it on a regular basis. Look at the example below. Example A client made an original investment of £50,000, with a portfolio spread based on careful asset allocation: Cash £5,000 10% With‑profits bonds £5,000 10% Collectives (UK) £25,000 50% Collectives (overseas) £10,000 20% Direct equity holdings £5,000 10% Total value £50,000 Five years later, the adviser held a review and, over that period, the investor had benefited from an inspired choice in his individual share portfolio. The position at that point was as follows. Cash £5,700 6.69% With‑profits bonds £6,500 7.63% Collectives (UK) £42,500 49.88% Collectives (overseas) £15,000 17.6% Direct equity holdings £15,500 18.19% Total value £85,200 The portfolio has increased by 70 per cent over the five years – a great result – but the original balance within the portfolio has changed. The proportion held in cash, bonds and overseas collectives has reduced and individual shares represent almost twice their original weighting. The client needs to decide if they are happy to continue with the current weightings in the portfolio – which differ from their initial plans – or to reweight it. The client appears to have made good gains in shares, but it might be a good opportunity to consolidate and move some of the gains into cash, bonds and collectives. One of the key jobs during the review is to re‑evaluate the client’s objectives and attitude to risk, and then to reassess the asset allocation. 14.2.9.1 Switching We are all aware of the FCA’s attitude to advisers who switch a client from one product to another – a practice often referred to as ‘churning’. Such a view may appear unreasonable, given that taking and reinvesting profits, timing investments and taking defensive action are all accepted principles of running an investment portfolio. The key point, however, is that any switching must be demonstrably in the client’s best interests, and the costs must be justifiable. The cost issue is to some extent diminished by the fact that many organisations offer low share‑dealing costs and rebates on initial fund charges – in many ©LIBF Limited 2024. All rights reserved. 397 14: Advice cases, switching funds can be arranged at little or no cost, although the adviser’s charges must also be considered. Examples of legitimate switching include the following: ‹ Changes in the client’s circumstances or objectives may cause a rethink in the overall approach and make an existing investment unsuitable. For instance, it would be appropriate to switch into less risky investments as a client neared retirement in order to consolidate and protect gains made, or move from growth to income funds when the client needs to start taking income from the portfolio. ‹ It may be wise to ‘bank’ profits from an investment and rethink the strategy. ‹ As explained earlier, there may be a need to rebalance the asset allocation in a portfolio, either because previous performance has resulted in a shift away from the original model, or because it is appropriate to look for greater diversification. ‹ If an existing investment has failed to meet expectations over the medium to long term, the adviser may feel it is appropriate to switch to a fund or stock that offers better potential. It would usually be prudent to allow an investment that has not performed over the short term the chance to improve its performance. ‹ Market or economic conditions may require a change in approach: it may, for example, be prudent to switch from equities to bonds when equity markets are threatened or falling. 14.3 Environmental, socially responsible and ethical investment One important issue for many investors, which an adviser should take into account when putting together a portfolio, is that of environmental, socially responsible or ethical investment. Over the past 20 years, there has been increasing recognition that many investors prefer to invest in companies and funds that match their own beliefs or values. Socially responsible investment (SRI) covers a range of approaches, some of which influence where money is invested (ethically screened funds) while others do not (engagement‑only approaches, active voting policies). The former is often termed ethical investment (EI) and refers to specific funds; the latter is often termed responsible investment and normally relates to an approach adopted by a product or fund provider across all of its equity holdings. Ultimately, all asset management firms can use the voting rights attached to the shares they hold as a method of supporting and promoting responsible corporate conduct. The purpose of engagement is to encourage investee companies to adopt a better approach overall to business ethics. SRI combined with engagement is increasingly being viewed as an effective force for positive change. There are several hundred funds working on an engagement‑only basis at the present time, where stock picking is not affected by ethical screening decisions. Environmental (‘eco’ or ‘green’) investment is considered by some investors to be a form of SRI where investments are made in support of the delivery of environmental objectives. ESG is a form of ethical investing that focuses on three key issues – environmental, social and governance – while still maintaining the objective of making gains for investors. ‹ Environmental – treatment of the planet and how the natural world is affected by our actions. It would consider a business’s impact and approach in such areas as energy consumption, climate change, waste, deforestation, water usage and so on. 398 ©LIBF Limited 2024. All rights reserved.  14.3 Environmental, socially responsible and ethical investment ‹ Social – the company’s treatment of people. This includes employees, employees of suppliers and associated companies, and the local and wider communities. It considers issues such as employee relations, working conditions, community engagement, human rights, diversity and modern slavery. ‹ Governance – the running of the company. It considers issues such as the quality and effectiveness of management, diversity in senior positions, conflicts of interest, possible corruption and the approach to whistleblowing. Source: Forbes Advisor (2022) ESG investing takes a slightly different approach from other forms of ethical investment. It includes assets and firms that score highly on the ESG criteria and have a positive effect, instead of just excluding those that do not meet ethical criteria. It also places more importance on the balance between responsibility and profit, whereas other investments may prioritise ethics over performance. 14.3.1 Screening Ethical investment involves screening, usually on both a positive and negative basis. Negative screening is the practice of excluding companies from the list of allowable shares or bonds in which the fund manager can invest, on the basis of specific criteria, which might include a company’s involvement in one or more of the following: ‹ alcohol production and sales, and tacit promotion of youth drinking; ‹ animal testing (excluding pharmaceutical trials); ‹ directors’ pay awards unrelated to performance (‘fat cat pay deals’); ‹ genetically modified food/organisms; ‹ human rights violations; ‹ nuclear power/waste; ‹ pesticides in food and water; ‹ pornography and the exploitation of women; ‹ poverty at home and abroad; ‹ racial, sexual or age discrimination; ‹ selling arms to military regimes; ‹ tobacco and youth smoking; ‹ unequal opportunities and workers’ conditions in poor countries. Positive screening is the practice of including companies according to specific criteria, which might include the adoption of good policies on some of the above issues, as well as one or more of the following: ‹ community involvement; ‹ adopting an environmental policy and reporting on that policy; ‹ environmental management; ‹ packaging reduction; ‹ sustainable forestry. ©LIBF Limited 2024. All rights reserved. 399 14: Advice Britain’s first ethical fund was launched in 1984 by Friends Provident. In general, ethical funds offer similar objectives and choice to other investment funds. Indeed, at the present time, ethical investments are available in a number of asset classes, including: ‹ cash savings (with banks, run along ethical guidelines); ‹ corporate bonds (both negatively and positively screened); ‹ commercial property (applying ethical criteria to choice of property and tenant); ‹ UK and overseas equities (negative and positive screening, and engagement). There are SRI products available to meet all levels of investment risk. To meet a client’s objectives, the adviser should find out how the client feels about the various areas of negative screening, positive screening and engagement, and then find investment funds that provide: ‹ the best match to those criteria; ‹ the best match to the client’s attitude to investment risk. If a match cannot be found, then a compromise should be discussed and agreed with the client. Where suitable SRI funds are not available, the next best solution for the client is to use a product provider with a track record of responsible share ownership/engagement. This also makes sense for non‑SRI clients because corporate governance and corporate responsibility are now commonly recognised as topics of major importance to companies, investors and the public at large. High standards in these areas are necessary both for the financial success of companies and investors and for the long‑term sustainability and legitimacy of our economic system. The examples below illustrate the investment objectives and ethics of SRI OEICs. EdenTree Responsible and Sustainable UK Equity Fund Investment objective: “To achieve long-term capital appreciation over five years or more and an income, through a diversified portfolio of UK companies. The EdenTree Responsible and Sustainable UK Equity Fund aims to invest at least 80 per cent in UK companies whose primary listing is in the UK by investing in a portfolio of companies which make a positive contribution to society and the environment through sustainable and socially responsible practices.” Source: EdenTree (2022) ASI Global Sustainable and Responsible Investment Equity Fund Investment objective: “To generate growth over the long term (five years or more) by investing in global equities (company shares) which adhere to the ASI Sustainable and Responsible Investment Equity Approach. The fund will invest at least 70 per cent in equities and equity related securities of companies listed on global stock exchanges.” Source: abrdn plc (no date) It is clear that these funds’ aims look like most other funds, the difference being that the investments selected meet the ethical standards of the fund. 400 ©LIBF Limited 2024. All rights reserved.  14.3 Environmental, socially responsible and ethical investment Many ethical funds have a committee of reference to advise on companies that meet the fund’s ethical standards. The committee is made up of an external panel of experts and is independent of the investment management of the fund. Vigeo Eiris (formerly the Ethical Investment Research Service (EIRIS)) was set up in 1983 with assistance from a group of churches and charities that felt they needed a research organisation to help them put their principles into practice. Vigeo Eiris researches and screens companies worldwide in relation to their ethical stance, but does not make recommendations or give advice. It also engages in discussions with companies. The information it provides helps investors and fund managers to decide whether companies meet their ethical standards. The service is available to charities, fund managers and individuals. UK Sustainable Investment and Finance (UKSIF) – www.uksif.org – was established in 1991 as a membership network in the UK for socially responsible investment. UKSIF’s primary purpose is to promote and encourage the development and positive impact of SRI among UK‑based investors. UKSIF’s 250‑plus members and affiliates include retail and institutional fund managers, financial advisers, SRI research providers, consultants, trade unions, banks, building societies, community development finance institutions, non‑governmental organisations and individuals interested in SRI. The Ethical Investment Association (www.ethicalinvestment.org.uk) was established in 1997 as a UK trade body to support financial advisers who currently provide, or wish to start providing, ethical/socially responsible investment advice. They offer training days throughout the year. Each ethical fund must state clearly the criteria it uses to select investments. The criteria can be positive or negative – or both – and examples would be as follows. ‹ Positive – characteristics the company should exhibit: — good community involvement; — good training and employment practices – Investors In People, equal opportunities, etc; — strong environmental management. ‹ Negative – activities in which a company should not be involved: — exploitation or mistreatment of animals; — operation in, or encouragement of, oppressive regimes; — undertaking genetic modification/engineering; — production or marketing of tobacco; — weapons production. 14.3.2 Engagement Socially responsible investment has evolved over the years. In the early days, ethical investment only meant not investing in companies that took part in activities and practices deemed to be unethical. It was, at that time, a policy of avoidance. Many investors felt that this did not go far enough in meeting their ethical aims and sought to influence corporate decisions in relation to their ethical stance. This is referred to as engagement (formerly positive engagement), which fund managers can achieve in a number of ways: ‹ through the positive selection of companies with an ethical approach, rather than only the avoidance of those that do not meet ethical requirements; ©LIBF Limited 2024. All rights reserved. 401 14: Advice ‹ by using their shareholding to influence corporate strategy; ‹ by entering into discussion with company management to encourage more focus on ethical issues; ‹ by using publicity to apply pressure to companies. When advising on ethical investment, the adviser should ensure that the investor is aware that different funds have different criteria. They will need to make sure that the investor’s views are met by the chosen fund. The management structure and responsibilities for unit trusts are described in section 10.3. 14.3.3 Ethical investment indices In conjunction with Vigeo Eiris, FTSE has developed a ‘family’ of indices – FTSE4Good. The indices identify companies with the strongest records of corporate social and environmental performance. FTSE4Good offers four geographical indices covering the UK, USA, Europe and worldwide. 14.3.4 Is there a price to pay for ethical investment? To the surprise of many, ethical investment funds have generally performed as well as, and in some cases better than, their conventional counterparts. There are no additional charges for ethical funds. Ethical investment criteria can reduce the range of companies in which the fund can invest. The companies meeting the criteria are often smaller than the average company that attracts fund investment. In some cases, this can make the ethical fund more volatile and, using equities as an example, more akin to an equity growth fund. This also has the effect, however, of preventing fund managers from ‘hugging’ an index, which means that the funds are genuinely actively managed. 14.4 The advice Having established the client’s circumstances, objectives and attitude to risk, the adviser next needs to formulate a recommendation. In many cases the client’s objectives may be unrealistic in terms of the amount available to invest or the expected outcome. The adviser must manage the client’s expectations, which may require compromise or prioritisation of the needs and objectives. We considered the basics of constructing an investment portfolio in Topic 9, so we do not need to repeat the details here. The key points of the recommendation are that it should: ‹ meet the client’s objectives; ‹ be affordable; ‹ match the client’s risk profile; ‹ match the client’s ethical views; ‹ allow as much future flexibility as possible. 14.4.1 The portfolio We can refresh the basic steps of portfolio construction at this point. 402 ©LIBF Limited 2024. All rights reserved.  14.4 The advice 14.4.1.1 Asset allocation The first step is to decide on the asset classes to include in the portfolio and the weightings each should be given. For most advisers this will involve the use of a model portfolio, either provided by their own organisation or from another investment organisation. Clearly the allocation should reflect the client’s needs, objectives and attitude to risk. 14.4.1.2 Selecting the specific investments When selecting the specific investments to be made, the first decision is whether to use direct investments or collective funds. For many investors the funds route will provide diversification, economies of scale and ease of administration, but in some cases may not accurately reflect the investor’s own objectives and attitudes. This is because the fund is, by necessity, attempting to serve a wide range of investors. 14.4.1.2.1 Direct investment Investing directly in shares, bonds, etc, will require a great deal of research and administration, regular reviews and further dealing costs when investments are bought or sold, all of which will add to the management costs. 14.4.1.2.2 Indirect investment Using funds has advantages for most investors, providing the fund mandate meets the investor’s requirements. In broad terms, there are four options. ‹ Managed funds offer a broad approach and are usually separated into cautious, balanced and adventurous. Such funds operate within broad mandates and asset allocations. ‹ Specialist funds offer exposure to a range of underlying assets and market sectors. A few examples include: — UK equities – large and small companies, income, growth, recovery, etc; — UK bonds; — Asia Pacific; — Europe; — global growth; — global bonds; — North America; — emerging markets; — Japan. Each fund will offer its own unique mandate and asset allocation. ‹ Funds of funds and multi‑manager funds – these funds either spread the capital across a number of other retail funds to produce a balanced portfolio within an overall mandate (fund of funds) or use specialist external managers for defined sectors of the fund (multi‑manager funds). Caution should be used when considering investing in a range of funds of funds because certain well‑regarded individual funds will form the core of many of the combined funds. This means that the investor ©LIBF Limited 2024. All rights reserved. 403 14: Advice may diversify by investing in, say, four funds of funds, only to find that a number of individual funds appear in all of them. This clearly results in less diversification than originally intended. ‹ Tracker funds – these funds offer simple exposure to specific assets at relatively low cost. As discussed in Topic 9, by their very nature, tracker funds will always produce average returns compared with their sector, which may or may not be acceptable to the investor. Topic summary Each client is different – they have different needs, attitudes and priorities. In order to give appropriate investment advice to clients, an adviser must take all these factors and more into account. Armed with this information, the adviser can then make a recommendation. In this topic we looked at: ‹ attitudes to risk; ‹ client needs and objectives; ‹ client circumstances; ‹ the need for diversification and appropriate asset allocation; ‹ socially responsible (ethical) investment. 404 ©LIBF Limited 2024. All rights reserved.  Review questions and activity Review questions and activity The following questions and activity are designed to consolidate and enhance your understanding of the material that you have just studied. ‹ The review questions are designed to enable you to check your understanding of the topic. ‹ Completion of the activity will give you an opportunity to develop your understanding of the key themes in the topic. Answers to the questions are contained at the end of this book. Please note that the activity is open‑ended and that therefore a model answer is not provided. Review questions 1. Explain why debt repayment should be considered as part of an investment strategy. 2. Look at the portfolio below. What recommendations would you make? Asset Original Original Value allocation (%) investment (£) now (£) Cash 10 5,000 5,400 Corporate bond unit trusts 15 7,500 8,500 UK equity unit trusts 40 20,000 26,000 Emerging markets unit 15 7,500 15,000 trusts Direct equity holdings 5 2,500 5,000 Property funds 15 7,500 6,000 ©LIBF Limited 2024. All rights reserved. 405 14: Advice 3. In relation to ethical investment, explain the difference between positive and negative screening, citing examples. Activity Look at your company’s advice process and documentation. How does the firm assess the investor’s attitude to risk? Does the firm use model portfolios? If so, investigate how they are built and how they differ for cautious, growth and income investors. If the firm does not use model portfolios, how is asset allocation decided? References abrdn plc (no date) ASI Global Sustainable and Responsible Investment Equity Fund [online]. Available at: www. abrdn.com/en/uk/adviser/fund-details/asi-global-sustainable-and-responsible-investment-equity-fund/a-acc/ gb0006833718 EdenTree (2022) Key investor information: EdenTree Responsible and Sustainable UK Equity Fund [online]. Available at: www.fundslibrary.co.uk/FundsLibrary.dataretrieval/Documents.aspx/?type=point_of_ sale&id=e94cd2db-26f6-41d7-8fc7-bc58d4acbaaa&user=vZ%2b9qwWcSr5wKeRANdtRpd9FEGXbt2kijW0GTDzo Hj%2frE8SmbkTcNYdFLZZx0RJy&r=1 Forbes Advisor (2022) Best ESG funds [online]. Available at: www.forbes.com/uk/advisor/investing/best-esg- fund 406 ©LIBF Limited 2024. All rights reserved.