One of the prime tenets of wealth management is the delivery of sound, measured financial advice.
Advice comes in many forms: It can include counselling on asset allocation, assistance with saving for a first home, financial planning for retirement, or guidance on estate and trust matters. From an investment management perspective, however, the core foundation is built through the construction of a strong, well-diversified portfolio, one that will allow for solid risk-adjusted returns for years to come.
The portfolio management process itself involves multiple steps. A Portfolio Manager must balance a top-down assessment of the economy, forming views on interest rates, inflation, exchange rates and the overall health of the domestic and global market, with bottom-up analysis of individual investment opportunities.
Individual investments are assessed based on an outlook for the sustainability of the overall business, the health of the balance sheet, and an assessment of the valuation of the security compared to an ascribed “fair” value. These investments must then fit in the context of the client’s risk tolerance and objectives, not to mention be seen in the context of how they behave in an overall portfolio. It’s not a simple process.
Complicating matters is the sheer number of investment opportunities that now exist for investors. From individual equities and bonds to the multitude of managed products available, there is no shortage of investments to select from.
As one can imagine, a Portfolio Manager running a successful practice over many years will inevitably encounter a number of unique positions in their portfolios, whether from new client accounts transferring in from other firms, or through clients wishing to purchase specific investments based on their own research. Over time, the number of positions in an Advisor’s overall practice can easily balloon.
This was a prime motivation behind the Canadian Securities Administration’s (CSAs) introduction of new regulations addressing “Know Your Product” (KYP), part of the recent amendments to Client Focused Reforms. KYP’s purpose is to support and enhance the suitability determination, while increasing rigour and transparency around the securities and services Advisor teams are providing for their clients.
Investment firms and Advisors have an obligation to understand the investment needs and objectives of clients (“Know Your Client”), as well as the attributes and associated risks of products they are recommending to clients (“Know Your Product”) to meet suitability obligations and ensure clients’ interests come first.
The good news is that none of this is new. Advisor teams have been conducting research and assessing investments for quality and risk for as long as they have been in business. KYP regulation simply codifies and underscores the responsibility of Wealth Advisors and Portfolio Managers (together we refer to them as “Approved Persons”).
Thankfully today, there is no shortage of access to information, or technology. From analyst research reports to earnings calls, annual reports, fund fact sheets and bespoke research tools, there are many ways to achieve the goal.
There are, however, two changes we are likely to see moving forward — and they are both related. First, Approved Persons will have to think carefully about clients proposing trades. All trades require the Approved Person to conduct due diligence and remain up to speed and current on the investment. As one can imagine, if each client has even one or two unique positions, it quickly becomes a limiting factor in the Approved Person’s overall practice as the research burden increases exponentially. Similarly, we are likely to see the overall position count in an Approved Person’s business shrink. This is a good thing. In many cases, these “orphan” positions have built up over time, and each Approved Person no doubt holds many securities on their books which are owned by only one or two clients. There will inevitably be consolidation, and at Scotia Wealth Management they have built a mechanism to monitor and manage the overall position count for each Approved Person.
One vital caveat — KYP underscores an important point — that any evaluation of a security also takes into account the assessment of other reasonable alternatives. Consolidation of position count does not mean a more limited product shelf, or less choice for investors. It simply means Approved Persons will have more time and resources to perform product due diligence and make more informed choices on behalf of their clients.
Approved Persons must take steps to understand the securities themselves, including their structure, features and risk, initial and ongoing costs and the impact of those costs, sufficient to enable the Approved Person to meet the suitability determination and other regulatory obligations. The regulators are looking for Approved Persons to determine how the transactions and trading strategies can assist the client in achieving their objectives, and how market volatility could affect potential returns.
In addition to the Approved Person understanding the product themselves, they should be able to explain the product fully to the client including features, risks, and costs. Features will include potential returns, use of leverage, conflicts of interest, investment time horizon, and overall complexity of the security. Risks include disclosure of the possibility that clients may lose some or all the principal amount invested, liquidity risk, redemption risk, and risks from underlying derivatives or structure products, and conflicts of interest risk. Costs include fees paid to the Approved Person, or other parties including commissions, sales charges, trailer fees, management fees, incentive fees, referral fees, embedded fees, and executive compensation.
KYP is essentially an extension of each Approved Person’s duty to deal fairly, honestly, and in good faith with their clients. It is one of the most fundamental responsibilities owed by Approved Persons to their clients, along with the Know your Client (KYC) and suitability determination obligations.
The regulators have not specifically prescribed a format to evidence KYP, and each Wealth Advisor or Portfolio Manager is welcome to follow their own process. Next week we will outline The Greenard Group KYP process.
Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250.389.2138, email greenard.group@scotiawealth.com, or visit greenardgroup.com.
