Hidden risks of risk-rated funds
No matter how a fund’s risk rating is marketed, its exposure to risk can change greatly in the future
At the moment, it feels like nothing in financial services is quite what it seems. Is what you see with Libor (the London interbank offered rate) really what you get? And, maybe most importantly for your business, is the risk-rated fund that you are recommending to a client really risk-rated?
Investment advice has received close scrutiny from the FSA in recent years, culminating in March 2011’s finalised guidance paper ‘Assessing suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection’.
The paper was fairly extensive, as FSA documents tend to be, but the most central issues were the importance of thoroughly assessing a client’s attitude to risk, making recommendations that were suitable for someone with that average true range (ATR) of attitudes, and ensuring that every client advised by a firm underwent the same compliant process.
The FSA’s work on investment advice had been underway since 2006, so the majority of advisers sensed the way the regulatory wind was blowing and had adopted a suitable system long before the finalised guidance paper was published.
It is also fair to say that most advisers’ investment processes contain a double check that first establishes a client’s attitude to risk and then ensures they have got it right by cross checking the client’s tolerance for financial loss.
Most of these advisers would be horrified then to discover that, in spite of following a reliable and robust process with their investment clients and making suitable recommendations for fund solutions based on the output of that process, many ‘risk-rated’ funds are not actually as risk rated as they may first appear. In other words, the rating that indicates a fund’s level of risk may not correspond to the risks they are actually taking.
Making the grade
Risk-rated products are built on two axes: the asset allocation within the funds and the volatility of the fund as a whole. In theory, the capital of a client with an ATR rating of four should be able to be placed in a fund that is given a risk rating of four and left there confidently until their next review.
While it is common for risk-rated funds to match these permutations upon launch – or at the time of initial rating – there is no guarantees that they will continue to maintain this match in the future. Or, to confuse matters even further, some funds will continue to match the asset allocation of their original risk rating, but not the volatility range, or vice versa.
Although common sense would dictate that the changes between risk-rating categories would be gradual, the nature of the market at the moment means there could be fluctuations on a larger scale that could change overnight the nature of a fund your client has invested in. Without wishing to scaremonger, an adviser could do everything exactly the way they are supposed to in order to provide a client with the highest level of advice, and still end up with their client’s money invested in a way that is unsuitable to his or her attitude to risk.