Over the last few years I found myself having more and more discussions with fund groups and advisers around the solutions available for the more transactional segment of IFA client banks.
There are numerous options and it is clear that the FSA is keeping a keen eye on all areas of “outsourced” solutions.
We are focusing here on risk-rated funds (many of which are multi-manager and designed to map output from risk tolerance questionnaires) and multi-manager funds (that are not risk-rated) in two key areas: comparing what benefits each approach potentially offers advisers and clients and the key areas of due diligence for each to ensure appropriate selection.
The aim of this article is to point out areas that advisers may wish to consider when deciding which solutions are most appropriate for their client although my comments relate primarily to actively managed funds. I know from experience that due diligence on funds can be very time-consuming but hopefully these broad guidelines will be useful.
Risk-rated funds and non-risk rated multi-manager funds often take subtly different paths to achieving their goals.
Broadly speaking, risk-rated funds are designed to outperform benchmarks, often composite, but within a defined risk budget as measured by standard deviation (volatility), while multi-manager funds usually aim to outperform a sector or benchmark, and are less restricted by their use of risk.
The self-imposed restrictions on risk-rated funds can help protect relative downside loss. Many multi-managers will also use their skills to manage risk where their mandate allows them the flexibility to move in to more defensive asset classes or use derivatives to hedge positions. The main difference is that with risk-rated funds there is more certainty of approach.
It is relatively easy to do a high level assessment of a multi-manager’s performance against a sector average (against which many are benchmarked). Many risk-rated solutions are in the Unclassified sector, with a composite benchmark, so this is slightly more difficult.
Where providers assign a risk-rating to a fund, it should be remembered that this is not against any industry standard but usually against other funds within the company’s own range. A multi-manager fund may have different risk ratings depending on which distribution outlet is being used.
The key difference is that the relative risk profile of a risk-rated fund should not change but that of a multi-manager fund can, and often does, change, as a result of the fund managers’ current tactical view.
There are some risk-rated fund managers for whom the constraints imposed by the volatility ranges could make it difficult to outperform benchmarks significantly, net of charges, and this should not be expected, and clients need to be clear about this. Multi-manager teams, however, often have the flexibility to be able to pursue opportunities in asset classes or geographic areas without the same restrictions.
The temptation is to use either as a default option particularly for the more transactional segment of a client bank, but advisers should still conduct robust due diligence and review their recommendations periodically.
Areas
There are several key areas advisers should consider, and a number of pertinent questions they should ask, as part of their selection process for these fund types.
Organisational strength and depth of the fund - advisers should understand the strength, heritage and depth of team and process behind each fund and their exposure to key decision makers. There are a lot of managed solutions across the market run by relatively small teams of skilful individuals, but what succession plans do they have in place in the event of a key individual leaving?
Performance benchmarks – is the adviser able to quickly check a fund’s adherence to its objectives remembering that some risk-rated funds are run against composite benchmarks?
Comparing the performance of a multi-manager fund against a risk-rated fund is largely irrelevant. Multi-manager funds generally aim to outperform their peer group and depending on the flexibility of the manager’s mandate may take quite large bets at a fund or sector level in search of extra performance for their investors.
Risk-rated funds are all about generating moderate returns over their benchmarks but within a very controlled process driven largely by the volatility constraints imposed.
When assessing risk-rated funds advisers should also seek to understand if all funds within the range have consistent/linear performance characteristics and have they adhered to the volatility bands. Another simple way to assess the efficiency of any range of risk-rated portfolios is to plot the risk (as measured by standard deviation) and returns on a graph to see how consistently they remain within a relevant range on the ‘efficient frontier’.
A concern is that some risk-rated solutions may provide similar levels of return for different funds or generate similar levels of risk particularly if markets move aggressively between each quarterly asset allocation review.
Active and passive - How much is active and how much is passive and is this reflected in the costs and performance? Are passive vehicles being used to reduce cost, volatility or to gain efficient access to a particular asset class?
Fund diversification – do any funds have a very high weighting to an individual fund, increasing stock specific risk or are they more fettered with heavy exposure to one group’s range of funds. Does the fund group use derivatives to manage risk or add performance or gain exposure to a particular market or asset type and do they have the relevant experience and resource to trade in derivatives? Does the fund gain some (indirect) hedging through the use of absolute return funds or structured products?
Asset allocation – when analysing risk-rated funds an adviser should understand if the fund’s asset allocation is based on the views of a committee or from a stochastic model, possibly with a tactical overlay to reflect current market conditions? If a team is making these decisions within each portfolio, do they have a strong heritage in making successful asset allocation decisions? If the asset allocation is based on a stochastic model, how does the fund manager cater for new asset classes or those with very attractive valuations?
How often are asset allocations reviewed? Some multi-manager funds and indeed risk-rated solutions will dynamically review asset allocation while some funds review asset allocation quarterly. There is nothing wrong with this however market movements could have quite an effect on the actual asset allocation of a multi-manager fund or risk-rated solution ‘intra quarter’. Advisers should also be aware if a fund group uses a fairly static strategic asset allocation benchmark as this may make it difficult to generate returns within volatility bands – for instance a fund may have been structurally overweight in gilts last year and provided stellar returns, however what happens if confidence returns or gilts are no longer one of the ‘safe havens’ of choice? Will the fund group be able to react to this or will they be constrained by outputs from their models?
When assessing multi-manager funds it is also important to understand the manager’s stance on asset allocation. Some multi-manager funds may take a more core approach where asset allocation may not deviate significantly from its peers and the manager and team will seek to add incremental value through good fund selection. At the other end of the scale there are multi-managers who see decisions on asset allocations as hugely important, these managers will make their own assessment of the global economic environment and if they are strongly positive on a particular market they may take a significant overweight position.
There is no right or wrong way but an understanding of how any of these funds decides on asset allocation strategy is so important because a) numerous academic reports suggest it is a key influence on providing returns in line with investor expectations; and b) an understanding of a fund aims and objectives will help manage client expectations.
Distribution – if the adviser has chosen their platform(s) or product(s) of choice but their favoured range of funds is not available should this influence the decision on which fund? Does the adviser go off platform and what if a client’s circumstances change and a switch is required?
Cost – disproportionately high charges will of course affect returns to investors so should be considered in the context of what each fund is trying to achieve and its success in doing so.
While the regulator is clearly concerned about investors being shoehorned in to default solutions with no regular reviews on performance and adherence to aims and objectives being carried out, I certainly sympathise with advisers who not only have to assess what type of solution is suitable for a client but also what fund or range of funds is most appropriate.
Whatever solution is chosen I would always advocate a ‘look beneath the bonnet’ before recommending, to understand how a fund is constructed, the expertise of the people constructing it and their success in achieving the aims and objectives of the fund.
Adrian Gaspar is senior consultant of Defaqto
