The landscape of the UK advice industry fundamentally changed when the retail distribution review came into effect. Trail commission disappeared and the industry had to move towards fee-based models, with a greater focus on risk and suitability. Something that has not changed however, and which is fundamental to best practice, is to put the needs of the client first.
It has become more important that fund managers understand the retail backdrop and deliver solutions that can stand the test of time. One of the key ways of smoothing the transition into the post-RDR advice model is for investments to be more directly aligned with the process of risk assessment. With this in mind, before designing any solution, understanding the needs of both advisers and investors is of utmost importance.
Wish #1: Suitability
One of the big challenges facing advisers is to continue providing a high quality service, while not alienating those who may be less willing to bear the cost of traditional models. The people who fall into that category are the high net worth clients of tomorrow, so it makes good business sense to cater to them now.
Any solution to bridging this advice gap must adhere to the FCA’s principles of “knowing your customer”. Advice must be bespoke, and of course, the products must be appropriate for the investment goals and especially risk tolerance of the individual client. Fortunately, a number of services have now sprung up to assist advisers by risk-rating various investment products. Of course, assigning a risk rating to funds is not a new idea, but when combined with a matching methodology for assessing an investor’s risk tolerance, it creates a powerful tool for building an investment portfolio. This empowers advisers, letting them see which funds have a volatility profile that is consistent with risk their client is prepared to take.
So far, so good, but unfortunately there’s a snag. Financial markets change all the time as political and economic events impact the world; so a fund that is rated five today, for example, could easily be rated four or six in a year or two’s time. If that happens, then the investor will no longer be holding a fund that matches their desired outcome and attitude to risk.
Where risk-rated funds fall down, risk-targeted funds have emerged to fix this problem. These are funds that specifically aim to always match a particular risk profile. So if it is rated five today and the investment environment changes the fund managers can adapt the portfolio so that the rating does not deviate – it will remain rated five and the investor will continue to have the same type of investment that they chose originally – therefore the fund should be suitable but most importantly remain suitable.
Wish #2: Flexibility
Being active in asset allocation was seen by advisers as the second most important characteristic they wanted to see in a multi-asset strategy. Where a risk-targeted fund comes into its own is in how it is managed, with it being paramount to monitor the portfolio on a daily basis and make adjustments to the mixture of asset classes to adapt to changing market conditions.
The chart shows that in the past 10 years, the best- and worst-performing of the key asset classes has changed frequently. Ultimately, it is likely to be asset allocation, rather than specific fund selection, that is the key determinant of risk and therefore returns – so it makes sense for fund managers to focus on that aspect of portfolio construction.
Government bond yields are a prime example. In the past, these would have been seen as one of the safest investments you could buy. Times have changed, however, as central banks have tried to stimulate their economies by taking unprecedented steps to encourage governments, companies and individuals alike to borrow at very low interest rates.
Any assessment of the future path of bond returns must therefore be rescaled to take into account the base from which yields start at today. Given that yields are currently so low, it is unrealistic to expect a similar period of falling yields. Forward-looking risk management tools need to be developed and utilised.
Wish #3: Value for money
Low-cost portfolio solutions have become crucial, both for advisers who are under pressure to reduce costs themselves, and for the end investor who naturally want the highest possible proportion of their money working for them.
Multi-asset funds are increasingly utilising index funds to achieve this as using inexpensive building blocks means the cost of the overall portfolio can be kept low. Some multi-asset managers will choose to supplement core index funds with selective active funds, perhaps in asset classes where there are few passive alternatives such as commercial property. Blending passive and active funds can increase diversification and improve the asset mix of the portfolio without unduly influencing cost. Of course, a financial adviser can adopt a similar strategy themselves if they deem it appropriate, using a low-cost risk-targeted multi-asset fund as the principal holding in a client’s portfolio, but perhaps also adding some satellite holdings in more specialised areas.
Getting good value for money is not just about low costs, of course: getting good quality for that price is vital. It is a misconception that risk-targeted funds only care about volatility and not performance. In fact, the aim of risk-targeted funds should be to deliver the best return within certain risk parameters. Performance is therefore fundamental, and the risk-targeted element serves to provide advisers and investors with the comfort that the strategy will remain aligned to the appropriate profile. It is also important to remember that volatility is simply one measure of risk. There are many risks that are not captured by volatility, such as inflation risk, illiquidity risk and active manager risk.
Multi-asset managers must consider all of these, but ultimately the main risk that concerns investors is the risk of losing money: risk-targeted funds must seek above all to generate the best possible long-term return within their risk parameters.
There is no panacea for determining the correct asset allocation to meet a given set of investment objectives. Risk is a multi-faceted problem and has to be analysed in a number of different ways. The key is to do so smartly and not just rely on a simplistic view of past performance to guide future investment decisions. The investment world has changed a lot in the past few years, because of the upheaval caused by the credit crisis, but also because the investment industry has reacted to the changing needs of investors.
In the past few years advisers have been clear to me about what they and their clients want to see in their multi-asset solutions. It is now up to fund managers to adapt and deliver.
Justin Onuekwusi is a multi-asset fund manager of Legal & General Investment Management
