Temenos, the technology firm, examines the complex issue of automated investment profiling, a key issue at a time when firms are trying to get a better grasp of clients' risk tolerance and ambitions.

The authors of this feature are Lynne Landau, product manager for private banking, and Thibaut Jacquet-Lagrèze, product strategy director, at Temenos. Before the financial crisis, investment profiling was simplistic, limited to understanding a client’s risk tolerance and agreeing on a trade-off between risk and expected return. Conservative investors would be offered a few investments with a predictable return, whereas more aggressive or long-term investors would be offered more risky investments. An investor aiming for a good balance between security and risk would be assigned a combination of investments in safe, fixed values (bonds) and shares. These investment strategy classifications served as a proxy for risk tolerance while often using simple volatility to quantify risk. The crisis showed flaws in this approach, since strategies to avoid volatility did not necessarily limit downside risk and many pre-crisis models didn’t account for the market extremes that occurred. The crisis could not protect all conservative investors. The sudden change to the credit risk of banks and governments and the related ratings turned low risk investments high risk overnight.

The 2011 Capgemini/Merrill Lynch Financial Advisor Survey reports that high net worth investors have regained trust in advisors whereas “trust and confidence in regulatory bodies and institutions is far from restored.” Capgemini/Merrill Lynch further revealed that after the financial crisis the vast majority of HNW clients see effective portfolio management (94 per cent), specialised advice (93 per cent) and transparency on statements and fees (93 per cent) as being important. HNW investors are now much more engaged in their finances and are moving assets to firms that respond to their new requirements and demonstrate a more integrated approach. Determining an investment profile is not a one-time task; client needs must be monitored, reviewed and reassessed consistently.  Life changes such as a divorce often change investment goals and the client's risk tolerance.

Clients often have multiple investment goals, such as retirement and children’s education: each carries a different risk tolerance. To meet these requirements, wealth management firms need a complete picture of a client’s goals to understand what principal must be protected (house, business etc.), what portion of assets can be exposed to market risk and what assets might be set aside for aspirational risks where the client is taking concentrated bets to move his or her life to the next step, to grow wealth. Assets should be split by capital protection, market and aspirational risk, with each type of risk assuming its own asset allocation. Important goals can be managed separately with protected assets invested in safe bonds or money markets, with "nice to have" goals invested in a more risky portfolio. Banks are also faced with increasing regulatory pressure. According to Temenos Community Forum research conducted in June 2011, regulation and the cost of complying with regulation was cited as the biggest challenge banks are facing today (24 per cent).  This perception was shared evenly across all segments, tiers and geographies.

Only small anomalies could be cited – for example, only 18 per cent of Middle Eastern respondents regarded regulation as their biggest threat (compared to 33 per cent who said competition). During the last few years, governments have introduced new regulations to protect consumers. Worldwide, there are new ground rules regarding the conduct of wealth managers. Anti-money laundering rules and enhanced know-your-client rules, along with more stringent cross-border banking and tax transparency strictures, are increasing the cost of regulation. These new laws also call for more detailed investment profiling. For example, under the Markets in Financial Instruments Directive, banks must obtain information about a client’s financial situation, investment goals and knowledge and experience as an investor when providing investment advice. Information must be accurate and enable the investor to understand the risk and type of investments offered. MiFID II takes this further by ensuring the advisor is qualified to recommend asset classes such as derivatives to clients.  

In the US, the Dodd–Frank and Consumer Protection Act aims to bring greater public transparency and market accountability to the financial system and give investors important protections. The UK’s Retail Distribution Review requires a shift in traditional business models and pricing from product-based commissions to fees for advice. These rules place large administrative overheads on wealth management firms. Using software to register and manage investment profiles helps automate regulations and compliance rules and reduces the cost of implementing them. The system supports the proposition of a relevant investment strategy and asset allocation for the different subsets of the client’s assets, blocking the sale of inappropriate products. Information is processed automatically to suggest a risk profile and the output of the process is stored in a database for documentation purposes.  

Accurate customer data capture is key to identifying lifestyle and aspirational changes.  Modern software allows wealth managers to track changes in client needs and risk aversion and anticipate the impact on the risk profile and investment strategy. Any significant changes will then lead to a full reassessment of the investment profile and asset allocation. Software can also be used to set automatic limits and alerts to enforce legal and client constraints, generate a structured investment proposal or rebalance a portfolio. Automated investment profiling can help wealth management firms implement and enforce new rules while qualifying and classifying clients more appropriately and introduce controls based on detailed profiles. A streamlined and disciplined approach to profiling enables financial institutions to understand, reflect and document clients’ overall needs and goals more systematically. Wealth managers can then focus on value-added services and more effective investment strategies to improve the customer experience.