The Discretionary Mandate That Drifted
A Sofia-based investment consultant manages a discretionary portfolio for a client, Mr. Petrov, whose signed suitability profile records: moderate risk tolerance, 5-year horizon, maximum 40% allocation to equities, and no derivatives. Eighteen months later the portfolio holds 62% equities, 8% in leveraged ETFs tracking a volatility index, and 30% in short-duration bond funds. The client's stated goal was capital preservation for a property purchase in year five. The consultant argues that the equity overweight was justified because markets rallied and the client 'seemed comfortable' during a review call, and that the leveraged ETFs are 'small positions individually.' The internal compliance officer flags the file. The client has not signed any updated profile.
1. Assess whether the portfolio still meets the suitability requirements and identify the specific breaches.
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The portfolio no longer complies. Three distinct breaches exist:
- Equity limit: 62% versus a contractual ceiling of 40%. A mandate limit is a hard constraint, not a target to be renegotiated by market performance. The 22-point excess is a documented deviation.
- Derivatives prohibition: Leveraged volatility ETFs are derivative-linked products. The profile expressly excludes derivatives. The 'small individually' argument is irrelevant because the products are structurally leveraged and their aggregate 8% exposure can amplify losses severalfold.
- Horizon mismatch: A five-year property-purchase goal with capital preservation requires a de-risking glide path, not increased equity exposure. Reaching for return after a rally increases sequence-of-returns risk exactly when the funding date approaches.
The 'seemed comfortable' justification is not evidence. Suitability requires a documented, signed update to the profile before the risk level changes. Absent that, the drift is unauthorized. Remediation: restore the 40% ceiling, exit the leveraged products, document the rationale, and consider whether the client should be compensated for any losses attributable to the deviation.
2. Draft the remediation steps the consultant must take and explain how the drift should have been prevented.
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Remediation sequence:
- Immediately reduce equity exposure to at most 40% and liquidate the leveraged ETFs; these are unauthorized holdings, so the client should not bear transaction costs arising from the correction.
- Issue a written explanation to the client describing what happened, the deviation period, and any performance impact.
- Conduct a fresh suitability assessment. If the client genuinely wishes to raise risk tolerance, obtain a new signed profile with a documented discussion of the property-purchase deadline.
- Report the incident through the firm's breach log and cooperate with compliance review.
Prevention: The root cause is absent monitoring. A discretionary mandate needs automated pre-trade and post-trade limit checks against the signed profile, periodic drift alerts when allocations breach tolerance bands (for example, a 5-point band around the 40% ceiling), and mandatory re-papering before any change in risk category. Review calls should be minuted and any client comment about comfort recorded as information, not as consent. The consultant's own incentive to chase performance after a rally should be managed through a suitability attestation at each review.