The speed and depth of the stock market collapse earlier this year likely caused white-knuckle moments for many investors, with some reconsidering their appetite for risk. Yet, financial advisors also may be questioning the appropriateness of their clients’ portfolios. Their doubts, though, are not just the result of a more uncertain investment environment, but a host of new reforms poised to sweep through the investment industry.
Specifically, these “client-focused reforms” put more focus on the appropriateness of advisors’ investment advice for clients, says Debra Foubert, director of compliance and registrant regulation branch at the Ontario Securities Commission and chair of Canadian Securities Administrators’ (CSA) client focused-reforms policy project and implementation committees.
“We have been focused on creating a package of reforms that put the fundamental concept that clients’ interests come first when dealing with firms and individual registrants,” she says.
The client-focused reforms are amendments to National Instrument 31-103 and expand regulation around conflict of interest for investment recommendations, including more rigorous suitability standards as well as enhanced know-your-client and know-your-product guidelines.
Although the new reforms, expected to be fully in place by the end of next year, are viewed largely in a positive light by the investment industry, many advisors and their securities or mutual fund dealers are concerned they may bring new challenges.
“While the regulators have a duty to protect clients and the public interest, they may be handcuffing financial advisors,” says Steve Bokor, a portfolio manager with PI Financial Corp. in Victoria, who has more than 30 years of experience in the industry.
Namely, he foresees issues arising with how advisors build portfolios within the new regulatory framework in an increasingly risky investment environment. Mr. Bokor points out that the traditional asset-allocation rules based on a client’s age, need for income and time horizon have already become increasingly out of sync over more than a decade of low yields on fixed-income investments.
Traditionally, a retiree required a mostly fixed-income and cash portfolio with little exposure to equities, he says. But this low-risk approach doesn’t generate returns to meet lifestyle needs and keep pace with inflation in today’s world.
Many advisors have been addressing that need for income by adding more equities to retirees’ portfolios, but the reforms call into question whether this approach is actually suitable. Consider a widowed retiree who agrees to a dividend-heavy equities strategy and tells the advisor she understands the risks, Mr. Bokor says.
“Flash-forward six months … and the portfolio is off 15 per cent,” he says. “So, she goes to the regulators and [then] sues [the advisor], saying she could not afford to lose that much money.”
While the portfolio is likely to recover, Mr. Bokor says, “regulators will, in all likelihood, say she was too invested in stocks and fine the [advisor] and possibly the firm for unsuitable [recommendations].”
Under current regulations, the complaint would likely result in an investigation, but the new reforms increase the burden of proof regarding a strategy’s appropriateness, says Rebecca Cowdery, a lawyer and partner at Borden Ladner Gervais LLP in Toronto.
“The client-focused reforms are really super-sizing existing regulations,” she says. “There was always a requirement to know your client [and] to make recommendations to your client … that are suitable.”
But the new reforms aim to provide greater clarity about putting clients’ interest first and, in turn, to eliminate some of the complaints investors make against advisors and their firms, Ms. Cowdery says. Chief among them are churning investments to generate commissions and recommending products that benefit the dealer and advisor more than the client.
Although she notes that most firms and advisors don’t engage in these activities, the “rules are written for the lowest common denominator – and they’re often written from a regulator’s perspective, which sees the bad stuff and the bad apples.”
For the good apples, though, providing investment advice in the current market climate coupled with new reforms present real challenges, says Martin Pelletier, portfolio manager with Wellington-Altus Private Counsel Inc. in Calgary.
That’s particularly the when it comes to determining risk, as many clients’ appetite for it has been diminished after the stock market rout earlier this year.
“There’s been a lot of fear, and that no doubt is having an impact on investors’ willingness to take on risk,” he says.
But that only speaks to one side of risk. Even when clients are comfortable with stock market risk, they may still not be suitable for certain products because they don’t have the financial capacity to endure the potential losses associated with them.
Yet, Mr. Pelletier says advisors are gravitating toward dividend-paying stocks, real estate investment trusts and alternative investments more and more, all of which typically entail higher risk, in retirees’ portfolios to offset low yields from bond allocations.
In turn, advisors may have to reconsider those strategies and offer some clients non-investment strategies instead, Ms. Foubert says.
“If clients’ goals and objectives cannot be achieved without taking greater risk than they’re able or willing to accept, then the registrant’s job is to explain alternatives,” she says. “Those might be saving more, spending less or retiring later.”
In addition advisors will need to look to tax, insurance and financial planning strategies to help offset lower return expectations, Mr. Pelletier says.
“These are the areas of additional value that an advisor can [provide],” he says.