MiFID II: Putting the investor first

ESMA recently issued additional MiFID II guidance, highlighting yet again the need for improvement in how the legislation has been applied to investor suitability assessments. Consistently suitable advice requires first seeing, and then meeting, the spirit of the regulations: the rules are there to serve a human investor.

Amid all the moving markets, changing client circumstances, and plethora of product offerings involved in delivering suitable financial advice, you could think that meeting regulatory requirements was the easy bit. The point of rules, regulatory or otherwise, is that they clearly tell you what to do (or, more often, not do). They set unambiguous boundaries within which advisers can practise their art. Unfortunately, this is not what we see.

We have worked with advisory firms across Europe on ensuring their suitability processes comply with MiFID II. We have seen a lot of confusion.

We’ve even seen some major firms opt to shirk their responsibility: asking investors to sign off on their own risk level, despite the legislation specifically prohibiting this! (See especially Article 54, Paragraph 1 of the Delegated Regulation, and Paragraphs 11 and 14 of the 3rd of April 2023 Guidelines).

MiFID II is a ‘Directive’, not a ‘Regulation’. Directives tell national regulators what they should aim to achieve, but it lets each country decide how they go about achieving it. Beyond that, individual organisations’ compliance departments then decide how to interpret their respective country’s interpretation.

Trouble arises when ‘open to interpretation’ becomes ‘focus on what can be precisely defined in legalese, and hope everything else takes care of itself’. The spirit of MiFID II – with which firms must comply, and against which their advice will ultimately be judged – goes beyond even the most obsessive checking off each of its component parts. It requires firms to take a more holistic view of the investor and their best interests.

This is why alongside the formal directives, ESMA issues guidelines, to remind firms what it is they’re supposed to be doing but are prone to overlooking when they narrow their focus to meeting each numbered paragraph in turn without considering the overall intent.

The latest, ‘Guidelines on certain aspects of the MiFID II suitability requirements’, published on 3rd April 2023 could be summarised as ‘remember you’re aiming to help a human, not to justify putting ticks in a series of boxes’. This is especially relevant to the requirements to account for investors’ sustainability preferences, which, being the newest requirements, are also the most inconsistently applied.

Of course you still have to meet requirements! But stepping back to consider how these requirements can be best met in the context of the legislation’s overall intent can pay enormous dividends for both advisers and their clients.

You can follow a rule and still be heading in the wrong direction

Rules are robotic. That is their strength, but, when it comes to helping individual humans, also their weakness.

For example, consider the issue of disclosure. The original legal requirement is to send clients certain information, such as the various risks inherent in investing. That’s very easily done. However, the point – the reason regulations exist – isn’t merely to send an investor information. It’s for them to understand it in the context of their investing actions.

We know that the message that’s sent is not always the same as the message that’s received. Which is why this guidance supplements the need to send information with the need to design it to be effective:

"Provided that all the information and reports given to clients shall comply with the relevant provisions (including obligations on the provision of information in durable medium), firms should also carefully consider whether their written disclosures are designed to be effective."

You can’t measure ‘careful consideration’ or effectiveness like you can simply sending something out, but that doesn’t mean it’s of lesser importance.

Below, we take a high-level look at the mistakes we most commonly see in application of MiFID II.

Six common MiFID II mistakes

1. Confusing Risk Tolerance with the right level of risk for an investor to take

When MiFID says (as it does, in Article 25, paragraph 2) that you need to obtain necessary information about a client’s Risk Tolerance, it does so as part of a package of information that needs to be considered (including knowledge and experience, financial situation, and so on).

However, many firms directly map the Risk Tolerance score to an investment. Have high Risk Tolerance? Have a high-risk investment. In all contexts, this is a poor process, and in most contexts, it delivers an unsuitable outcome.

In general, terminology around risk preferences can be very ill-defined, often with the same term being used for quite different purposes, sometimes in the same document. This makes it understandable that confusion arises, but it doesn’t make it okay.

Risk Tolerance is the anchor point in determining an investor’s Suitable Risk Level, not the end point. Their financial circumstances (which a comprehensive measure of Risk Capacity should cover) is often a greater influence. The Suitable Risk Level should also reflect likely short-term emotional responses to the investment journey (for which Composure is a proxy), and the investor’s Knowledge and Experience.

A related error that’s worth highlighting here is the tendency to assess and apply ‘Risk Tolerance’ at a portfolio, or ‘pot’, level, rather than an investor level.

Risk Tolerance should not be measured in relation to only investible assets. We know that investors have different tolerances for risk with small proportions of their portfolio versus large (see Rabin 2003) so we cannot measure Risk Tolerance of small gambles (investible wealth) and apply it to large (total wealth) risks, and vice versa. Risk Tolerance needs to be anchored on something that remains consistent across investors regardless of differences in their circumstances, and the only consistent anchoring point is their overall net wealth.

Risk Tolerance (measured properly) is a psychometric trait of the individual. The right level of risk to take may differ between two investors with the same risk tolerance and same amount of money to invest, and vastly different non-investible wealth, but that non-investible wealth shouldn’t affect their Risk Tolerance score.

There are many other common failings in the measurement and application of Risk Tolerance, which we look at here.

2. Not combining Risk Capacity and Risk Tolerance in a meaningful way

Risk Capacity (also known, with occasionally differing definitions as capacity for loss, or ability to bear losses) is how an investor’s financial circumstances are accounted for in determining the right level of risk for them to take. If an investor is heavily reliant on their investments to fund their lifestyle, the right level of risk for them is different to an investor with the same Risk Tolerance and investible assets but whose lifestyle is less reliant on their investments.

The important point is that Risk Capacity is about an overall financial situation, not merely the answer to a simple monetary ‘stress test’ of a portfolio, which a narrow focus on ‘ability to bear loss’ often erroneously ends up encouraging. The guidance addresses these issues as follows:

"Information necessary to conduct a suitability assessment includes different elements that may affect, for example, the analysis of the client’s financial situation (including his ability to bear losses) or investment objectives (including his risk tolerance)."

A piecemeal approach that separately ticks off Risk Tolerance and Risk Capacity all too often overlooks that they need to be measured in a way that enables them to be sensibly combined into the overall suitable risk level. If not, you end up being forced to ‘adjust’ Risk Tolerance because of Risk Capacity in an inconsistent, subjective, and sketchily evidenced way. For example, you’re expecting a big inheritance, therefore you can afford to take ‘more’ risk with your investments.

Combining Risk Tolerance and Risk Capacity means more than a finger-in-the-air ‘adjustment’ to Risk Tolerance based on an investor’s age, cash reserves, or even the output of a cash-flow model. It means having a mathematically sound methodology for measuring Risk Tolerance and Risk Capacity in the same language, so that any adjustments are consistent and robustly evidenced.

Risk Capacity, properly measured, is a calculation, and one that accounts not merely for how much an investor could ‘lose’ before it affected their lifestyles. For many accumulating investors, they could, in the short and medium term, lose all their portfolio without it affecting their lifestyle expenditure. However, this doesn’t mean they should be taking maximum risk!

A financial situation includes not only assets, but time and objectives (which we’ll come on to next). And financial situations change… all the time! A Capacity calculation should therefore be dynamic, responding quickly to any changes in the investor’s financial circumstances… something most cash-flow modelling approaches don’t adequately cater for.

3. Measuring objectives and time horizons in relation to an investment, not an investor

Time horizon(s) and objective(s) are another common source of confusion. Interpreted as saying ‘thou shalt consider objectives and time horizons’, the rules lead some to attach a specific objective and time horizon to a specific pot of money.

Yet what we want to do is account for the changing and valuably fuzzy lifetime needs of human clients, not the needs of a pot of money.

General investment objectives can be seen as a balance between growth and protection. This is reflected in Risk Tolerance. Specific investment objectives are reflected in Risk Capacity. Properly measured, the Risk Capacity calculation includes considerations of all anticipated spending goals – it is an investor’s objective to have the money, at the stated time and priority, to fulfil each goal.

Though the regulations do not spell this out (yet), emotional comfort throughout the investment journey can also be considered an ‘objective’. Information on this is gathered by measuring Composure and other dimensions of Behavioural Capacity, which we’ll look at next.

Human investors do not have a single time horizon. They have multiple spending goals, and thus multiple times at which they need money to be available, in differing amounts, with differing certainties, and with differing priorities (some goals may disappear altogether, just as new ones may arise). Therefore, a holistic approach across each of these elements and all spending goals is required to understand the effect of time horizons on the suitable risk level – something a tick in a ‘short’, ‘medium’, or ‘long-term’ box cannot account for.

We would also add that just as humans make plans, they also change them – a lot. This obvious point is ignored in many assessments. An investor’s financial circumstances change, so to remain meaningful a fit-for-purpose suitability assessment requires dynamic updating in a low friction way.

4. Failing to measure investor behaviours in a robust scientific way

An investor’s ability to take risk is primarily about financial circumstances. However, ability doesn’t stop there. In addition to this financial ability to take risk, each investor also has an emotional ability to take risk: a Behavioural Capacity that determines how best to interact with investments to ensure ongoing comfort with the risk being taken.

It doesn’t matter how good a plan is if the person it’s written for doesn’t stick to it, or feels anxious doing so. Indeed, the theoretically ‘perfect’ portfolio could be the very spark for some distinctly imperfect behaviours. Emotional ability is not about financial circumstances, but financial personality.

Behavioural Capacity reflects tendencies to deviate from long-term, stable, Risk Tolerance due to short-term context and emotional responses.

The regulations are slowly – but surely – reflecting the reality that humans do not turn into robots when they start to own investments. Guidance both in Europe (and especially in the UK) is beginning to hint at, if not spell out, the need to consider investor behaviours in a reliable, systematic way.

For example, the latest guidance states, in the context of relying on ‘tools in the suitability assessment process (such as model portfolios, asset allocation software or a risk-profiling tool for potential investments)’ that the tools…

"…should be designed so that they take account of all the relevant specificities of each client or investment product. For example, tools that classify clients or investment products broadly would not be fit for purpose."

Specifics of financial personalities (an investor’s behavioural traits and tendencies) are very obviously very relevant. Broadly classifying clients according to demographics is not fit for purpose. We’d be surprised if the need to consider investors’ emotional responses as part of the suitability journey were not specifically highlighted in future guidance.

5. Confusing owning (or not owning) different types of investment with having knowledge and experience relevant to the investing experience

Typically, Knowledge and Experience is assessed by asking an investor if they’ve invested in a list of different types of investments. This isn’t very useful. For instance, if someone has never invested before, and lacks experience, should this preclude them from the portfolio that is right for their needs?

The guidance sets out to correct this:

"In assessing a client’s knowledge and experience, a firm should also avoid using overly broad questions with a yes/no type of answer and or a very broad tick-the-box self-assessment approach (for example, firms should avoid submitting a list of investment products to the client and asking him/her to indicate which products s/he understands)."

Once again, the emphasis is on each investor’s understanding as a whole, rather than merely their more limited specific knowledge or investment history:

"Information collected by firms about a client’s knowledge and experience should be considered altogether for the overall appraisal of his understanding of the products and of the risks involved in the transactions recommended or in the management of his portfolio."

Part of this is a greater emphasis on understanding of characteristics and mechanisms rather than merely the names of products, say:

"Firms should adopt mechanisms to address the risk that clients may tend to overestimate their knowledge and experience, for example by including questions that would help firms assess the overall clients’ understanding about the characteristics and the risks of the different types of financial instruments."

Oxford Risk’s tools assess Knowledge and Experience using both non-subjective measures (education, years investing, etc.) and personally reported measures (such as questions testing their knowledge on certain investing fundamentals).

6. Assessing sustainability preferences in a shallow way

The newer a set of rules is, the more guidance tends to be issued to help firms get to grips with it. The newest rules relate to sustainability preferences. There are multiple pages of guidance to tackle the shortcomings that are being seen in response to these rules.

The key point is depth – an encouragement to move away from a cursory question along the lines of: ‘Are you interested in sustainable investing, yes or no?’

"In order to help clients understanding the concept of “sustainability preferences” […] and the choices to be made in this context, firms should explain the terms and the distinctions between the different elements of the definition of sustainability preferences […] and also between these products and products without such sustainability features in a clear manner, avoiding technical language. Firms should also explain terms and concepts used when referring to environmental, social and governance aspects."

"The information on sustainability preferences […] should be sufficiently granular to allow for a matching of the client’s sustainability preferences with the sustainability-related features of financial instruments."

Oxford Risk’s Financial Personality Assessment measures sustainability preferences on multiple different dimensions, designed to provide stable and sophisticated insights, anchored on fundamental factors of each investor’s personality.

Compliance with MiFID II requires responding o the rules in the context of the human customer they're designed to help

It’s certainly tempting, when presented with the numbered paragraphs of a legal document, to work through ticking off each requirement one by one. However, it’s precisely because so many advisory firms view their compliance process in such a way that the regulators issue guidance telling them not to.

Where giving suitable advice to a human investor is concerned, it’s possible to check every box and yet completely miss what’s actually being asked for.

The challenges presented by MiFID II are less challenges of providing suitable advice, and more challenges of evidencing and presenting a suitable advice process to both the regulator and the clients. They are more structural than advisory. This means meeting them requires a set of scientific tools that work with existing adviser skills in obtaining, interpreting, processing, presenting, and recording information.

The list of MiFID II requirements may be long, but the key to understanding the solutions is simple: it’s all about client insights. Better insights into a client’s financial, psychological, and emotional situation; better evidencing of these insights; and better presentation to clients of how these insights about them match up with suitable investments for them.

To hear how Oxford Risk’s suite of scientific suitability tools can help you meet these challenges, please contact us.