The unprecedented financial crisis of 2008 has redefined everyone's perception of risk, sending private wealth managers back to the drawing board to make sure clients really understand how risky complicated products can be.
Excessive leverage and a widespread under-assessment of risk triggered the current crisis, according to a new whitepaper from Odyssey Financial Technologies titled "The Consequences of the 2008 Financial Crisis on Private Wealth Management."
Many experienced private investors thought they knew what risk really meant, but they were wholly unprepared for what happened, the whitepaper said. Excessive greed, exaggerated leverage and unaffordable levels of debt were widespread, even among trusted companies and products with conservative reputations.
"Lots of clients, forgetting the potential investment risks a little too quickly, were simply not prepared to take the brunt of the heavy falls we're currently facing," said Antoine Duchateau, CEO of Odyssey. "Consequently, private wealth management institutions will have to apply stricter procedures aimed at protecting their clients by ensuring they understand the different risks linked to financial investments and only invest in the products they really understand."
Put to the test, it is now apparent that the traditional approach based on risk profiles is insufficient, the whitepaper said.
"The traditional approach has been to have a client go through a questionnaire of five to 10 to 15 questions that gives them a risk profile and tells them if they are more aggressive or conservative," said Didier Pitton, product marketing director at Odyssey. "But it's probably not enough. Investors need to better understand the kind of risk they are exposed to."
Private investors worldwide got a rude awakening recently when the market tanked, and their seemingly safe or moderately risky investments suddenly became very risky. Examples are low-risk money market mutual funds that lost money because they invested in subprime mortgage-related securities; mutual funds that became illiquid because of too many redemptions or holdings in auction rate securities; corporate bonds that lost value because of default risk worries; long/short market-neutral strategies that lost more than 10%; and a total loss on some structured products due to bankruptcy by issuers such as Lehman Brothers.
"Many private clients will blame wealth management firms for not properly explaining the risks inherent in investment portfolios and some sophisticated investment products," the whitepaper said.
"The financial crisis has already generated an unprecedented number of claims from private investors blaming financial institutions for not explaining the risks linked to some investment products," Odyssey continued. "All this derives from a lackadaisical attitude toward risk, pressure on client advisers to sell products that affect their commission, a lack of client adviser expertise and no systematic risk directives."
"Many products have evolved to become quite complicated," Pitton said. "There is a lack of transparency on how they are built and how they evolve. Often, neither the clients nor the advisers really understand the risk behind these products. The new trend is back to basics and less sophistication."
He said there have been a lot of problems in Europe as unregulated structured products began to combine fixed income benefits with investments in options.
"Very few investors understand investing in structured products," he said.
Due to a lack of understanding and transparency, investors in structured products unknowingly became exposed to counterparty risk through issuers like Lehman, he said.
"Private clients are now seeking more than ever to understand and even quantify how risk is created in a portfolio in both normal and abnormal market conditions," Duchateau said.
The risk profile questionnaire is still useful, Pitton said, but it should be combined with more advanced technology. Odyssey offers a different statistic called Value at Risk that can alert an investor if the risk of their investments starts to change.
"It is a good indication of what is really at risk if things go wrong," Pitton said.
Odyssey's Value at Risk statistic assigns clients a risk threshold or risk budget to keep them on track, and offers an easy-to-understand "traffic light indicator" to alert investors to sudden changes. It calculates the absolute risk of all the structured products daily by unbundling them to evaluate each risk factor within. This identifies the riskiest products on the basis of absolute risk, compares the risk of various structured products and identifies the products that contribute the most to the overall risk of the portfolio, Odyssey said.
"A wave of more stringent regulation and oversight is coming, and that wave is going to break squarely on the back office," said Kirk Botula, executive vice president and chief operating officer at Confluence.
"Complying with the impending demand for greater transparency will necessitate improved and increased financial, accounting and marketing reporting disclosure," said Dan Torrens, vice president of product management for Confluence and author of a whitepaper titled "Market Dynamics Underscore Demand for Back-Office Data Consolidation and Automation."
"Meeting these disclosure demands in a timely and efficient manner will place new burdens on fund administrators and require unprecedented flexibility and control in the back office," Torrens wrote.
"Financial institutions will have to redefine the content of their investment advice offering and make their asset allocation advice available to a wider public," Pitton said. "By pointing execution-only clients to more structured investment advice services and applying the tried and tested principles of asset allocation more rigorously, financial institutions will ensure that investors benefit not only from better protection but also from better portfolio performance." Pitton said most advisers are specialized in one area and aren't positioned to provide global advice. Advisers need to have more expertise in advising foreign markets, he said. Hopefully, the global market will be able to clean up the excesses of speculation in the next six to nine months, Pitton said.
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