FTAdviser.com

Advertising

The global financial crisis has caused sustained and debilitating damage to the stock markets, economy and investor confidence.

This most recent crisis has been unique in that it can not be compared to any financial or economic disaster from the past, leaving many confused about the future and anxious that no timescale for recovery could be determined by using the past as a yardstick.

This environment has bred herd mentality, with many investors exiting the retail investment market in their droves. However, where can they seek refuge? In the past, investors have naturally migrated to the relative safety of banks but, with the banks at the root of the international economy’s downfall and interest rates at historic lows, this option is no longer as attractive as it once was. Bonds, also considered a safe haven in the past, are similarly volatile and equities are a shadow of their former selves.

Following the principle of diversification one alternative to simply investing in the stock market is to spread cash between several different asset classes - equities, property, bonds and cash - through a multi manager portfolio – or perhaps a more evolved client-focused solution such as a risk-profile driven fund.

Risk-profile driven funds are actively managed multi-asset portfolios designed to maintain a predetermined level of risk to suit different categories of investor. Such funds are already big business in the US mutual funds market and similar investment vehicles are beginning to appear on the UK market. These are not to be confused with lifecycle or target-date portfolios, pension funds that reallocate risk and assets over time as they work to a predetermined maturity date.

Given the current tumultuous backdrop, risk-profile funds have significant potential in the UK market when considering that investors increasingly want solutions rather than products and that, with an ever tougher regulatory environment, advisers must ensure that clients’ overall investment portfolios remain suited to their risk profiles as well as ensure that the client is invested in the right underlying funds.

Another compelling reason specific to the UK market as to why risk-based funds are likely to become an increasingly important part of the investment landscape is the evolution of more client-focused regulations. Risk-based portfolios enable advisers to address a number of the concerns of regulators, including those raised by treating customers fairly, in a very practical way that helps deliver a robust investment proposition to their clients.

Currently only a few investment management firms offer risk-profile funds but they all follow the same basic principle – matching asset allocation with client risk to a ready-made portfolio which corresponds to the client’s specific risk profile. Their aim is to achieve consistent returns within the risk/reward tolerance specified for each particular profile by identifying the right combination of assets matched to the client’s appetite for risk, this can be reduced and the performance potential of the investment boosted.

To establish an investor’s optimum asset allocation and determine which portfolio matches their risk profile, first an objective measure of the client’s attitude to risk is required. Some of the risk profile fund providers use an online risk profiling tool, such as Distribution Technology’s Dynamic Planner. This enables the adviser to ask the client a set of questions designed to determine their attitude to risk and investing. Their responses determine an individual risk profile normally on a scale of 1 to 10. For each risk profile, based on historical data of equities, bond and property and factors in economic information such as inflation rates, there is a corresponding asset allocation breakdown across a number of different asset classes.

The most obvious benefit of a risk-profile fund is that it negates the problems of trying to narrow down the best funds yourself. There are currently over 23,000 funds available in the UK and the challenges of undertaking the task of matching the asset allocation to a client’s acceptable level of risk, in addition to achieving diversification, are vast.

Diversification is another plus with this type of product. Rather than a single-fund solution, a risk profile product spreads the investment between several different assets which often behave differently under the same economic conditions. With this type of approach, at least one or two different asset classes can be performing well even if the rest are in temporary decline. Adopting a scientific approach to asset allocation decisions should assist with reducing risk and optimising potential returns.

The majority of risk profile products offer rebalancing. Even initially well constructed, balanced portfolios with the right asset allocation and a good choice of funds can drift over time into a shape that no longer meets the client objectives or risk profile. Combine this with the need to constantly monitor individual fund holdings in an industry where this year’s star could become next year’s dog and it is easy to understand the challenge faced by advisers to ensure that they do not inadvertently expose clients to undue risk. Risk-based funds generally offer at least a quarterly rebalancing service, where the asset allocation is monitored against the corresponding risk profile and adjusted if there has been any movement away from the original risk profile.

Elsewhere, the actual underlying individual fund selection is often based on a multi-manager process that includes selection from across the entire market rather than their in-house funds, offering both the best fund management expertise and impartiality. Most of the products are available through multiple platforms, meaning that advisers are able to retain choice over which product wrapper is most appropriate for their client.

By adopting this low maintenance approach, the benefit for advisers is the potential to be more productive than before and better equipped to add value to their clients. Risk profile products offer advisers a clear alternative which can considerably reduce the costs and avoid risks of establishing their own model portfolios.

The risk profile approach will gain more traction as it ensures that advisers retain the pivotal role of reassessing the appropriate risk profile of the client as his circumstances change over time. Traditional multi-manager funds have seen strong take-up with advisers but if the US experience is anything to go by, risk-profile driven funds represent the next generation of retail multi-manager products.

John Yule is head of UK Retail at F&C Investments