Of the factors that affect the wealth management industry over the last few years the importance of the technological change and legal consi...

Of the factors that affect the wealth management industry over the last few years the importance of the technological change and legal considerations have been to the fore. An ever-increasing body of legislation and regulation that has added greatly to cost and bureaucracy has accompanied the advances in technology, which have allowed fund managers to achieve greater efficiencies. But, with the out-of court settlement between Merrill Lynch Investment Managers and Unilever Superannuation Fund at the end of 2001 the legal environment (known as ‘L’ in MBA-speak) has taken centre stage. The ‘L’ just got bigger. This has clearly concentrated the minds of institutional fund managers on their agreements with clients, particularly as concerns benchmarking and risk. In the private client area, wealth managers should also be considering the issues raised by this case – factors that have affected the institutional market can and do cross over to the private client arena, and those that ignore this do so at their peril. I cannot have been the only observer to be astounded by the approach to the portfolio management process taken within MLIM, especially where such a large and influential client was involved. There were two aspects to the problem as I see it; the client agreement, and the supervision process required to ensure compliance with that agreement. The conditions of the agreement entered into with the client specifically stated there would be rigorous monitoring of the portfolio’s asset allocation and risk profile. The approach to the supervision of the asset allocation and stock selection process was, quite frankly, surprising, and appeared on the reported evidence to be at best ad hoc, and at worst, ineffective. If this confusion and apparent problem with supervision was allowed to happen at the very top of the industry, how many other firms, with perhaps a large number of less valuable clients have taken an even less disciplined approach? Particularly in the private client market, how many time bombs are ticking away within the client files, where the original client agreement bears little resemblance to how the portfolio is actually managed, or where the basic ‘tick box’ mentality that often lies behind much client risk profiling has led to ambiguous or unclear agreements that can be easily challenged. Make no mistake, there are some who have pursued a rigorous approach in this area for many years; however, we are all aware of some who have not. The point at issue is whether private clients, or their advisers can ‘do a Unilever’. Will they shift the emphasis in a complaint from underperformance to the underlying causes of it? The temptation for some must be compelling. Let’s face it, two years of declining markets have left an awful lot of dissatisfied clients out there; they have real, and sometimes substantial losses. These clients may soon cause some reciprocal grief to their portfolio managers. Don’t forget that Unilever actually made a lot of money during the period at issue, just not as much as it felt it should have, had the portfolio been managed differently. Don’t forget also that over the last two years, many portfolio managers succumbed to the compelling urge to play with asset allocations to hitch their star to the telecoms, media and technology wagon, now sadly lacking any wheels. The argument that only the big institutional clients will bother to sue their fund managers is, quite frankly, irrelevant. The focus of most of the press coverage since the settlement of the case has concentrated on this area, and naturally so – big bucks make big headlines. But it is not only pension fund trustees who read newspapers. Private clients and their advisers will be fully aware both of the arguments and the outcome in this matter. While a lawsuit may not be a practical option for many private clients or smaller institutions, they now have another angle of attack. The regulators, in addition to their role as the provisional arm of the consumer association, could soon become the effective provider of legal aid to clients of investment managers for actions in relation to underperformance. Of course, the complaints will not be about underperformance – they will focus on unsuitability, on the risks agreed versus the risks realised. The financial threats to the industry posed by mounting customer dissatisfaction are real. The amount of time that compliance departments and management has to spend on complaints is rising all the time. A surge in complaints, which may well follow the publicity about the MLIM/Unilever case, would dramatically increase the compliance costs incurred within the private client and small institutional fund management industry. Just ask compliance officers and fund managers how much time can be taken up by a single complaint. Let’s take a typical instance: a firm has underperformed against benchmark, and a client complains that unsuitable (risky) stocks or funds were bought for his portfolio. The investment ombudsman wants the firm to prove how well it knew the client, how well it translated that knowledge into his client agreement, and how well it implemented the agreement in practice as regards supervision of the fund managers in asset allocation, stock selection and suitability in general. Did the firm, for example, obtain a mutually amended agreement when it increased the allocation of TMT stocks or funds? It is clear that in response to this type of inquiry a considerable amount of highly paid resource is going to be diverted for some time. Now multiply that out to ten complaints, now to a 100. Indeed, could we soon be staring at the jaws of a class action lawsuit, I wonder? Whither profitability now, at a time when revenues are already under severe pressure? It is said that an ounce of prevention is worth a pound of cure. Those at the top of wealth management businesses need to take this on board, and soon. A systematic risk audit of the client base may be seen as an unnecessary cost to incur at such a time as this, but the firms that avoid taking action now may find themselves bogged down later in a morass of complaints and internal investigations. Five clear and simple remedial solutions are as follows. Preventative action needs to be taken at the point a new client is signed up. It is no good simply checking through the files of existing clients without ensuring that new clients are taken on in the same manner as they always have been. Marketing officers, relationship managers, fund managers and compliance officers should all be part of the process of ensuring that client risk profiling is accurate, that the firm does ‘know’ the client. The firm must ensure that the agreement is clear and unambiguous, and suitable for the client. The benchmarks must be realistic and relevant. The fund management process must be structured and properly supervised, preferably by someone independent of the fund management process. It has long been a matter of some reassurance to the more mediocre or frankly slapdash investment managers that, at least in the UK, the regulatory authorities do not punish poor investment management per se. The legislators have not been tough on underperformance. This may not have changed overtly or explicitly. We could however be entering a year when they will become a lot tougher on the causes of underperformance, and when client complaints will focus on the causes of underachievement rather than the effects. Action now, or tears later; the choice is clear.