Risks and rewards of outsourcing solutions

Broadly, assessing client suitability examines two variables: assessing a client’s capacity for capital loss over a certain time-frame, and profiling that client to calculate what risks they should take. The latter is negotiated through the use of risk profiling tools, as well as good old-fashioned conversation, to gauge and agree a client’s propensity for ‘risk’ overall.

After this profile has been determined, an investment portfolio is subsequently created and monitored around it. This has already given rise to an important shift, accelerating the outsourcing of clients’ investments, as advisers compensate for gaps in their expertise. Furthermore, this allows advisers to concentrate their businesses and frees them up to offer more holistic financial planning.

The very notion of suitability is set to alter the landscape even more markedly, prompting a need for risk-targeted funds that target a set level of risk - as opposed to risk-rated funds whose risks are simply rated - as regulators compel advisers to ensure their clients’ objectives are always met. However, there are very important distinctions between risk-rated and risk-targeted funds, and any lack of understanding could mean some serious problems down the road for fund-buyers and clients alike.

Risk-rated funds

Essentially, risk-rated funds offer a snapshot of ‘risk’ that is attributed to a fund. This does not mean, however, that the fund somehow specifically aims to attribute that level of risk. By buying a fund with a certain risk rating, an investor is buying a fund that displays a specific level of a risk at a specific point in time, and one that is not reflective of the level of risk that a fund manager might take in future. This might make it unsuitable for that investor overall. The idea that one can control risk through one’s exposure to equities alone is patent nonsense, as evidenced by ‘Cautious Managed’ funds, where the dispersion of three-year risk ranges from sub-gilt volatility (4) to stockmarket-like volatility (14+). The point is that investors need to look under the bonnet of a fund’s objectives and targets.

Risk-targeted funds

Whereas risk-rated funds view risk, and all its influences, as static, fluidity is the hallmark of the risk-targeted fund. The ‘target’ offers an explicit measure of the risk that the fund manager is prepared to take. This does not guarantee that capital cannot be lost, but it does commit the fund manager to working within certain parameters. For this reason, risk-targeted funds will assume a greater importance over the next 10 years or so.

Risk-profiling tools

The industry is still hampered by the slavish use of historic, stochastic models as risk-profiling tools. This is reasonable if there is a 20-year time horizon involved, but by and large they ignore the build-up of events that can drive a significant change in the value of an asset class. Current, ultra-low gilt yields demonstrate this point: again, most ‘Cautious Managed’ funds have a high level of exposure to gilt yields. They work on the assumption that gilts still equate to a safe haven, but in such an exceptional environment, who knows when they will reverse and to what extent. In that eventuality, can we say in earnest they are low risk? This exemplifies the need for a forward-looking model, which has the flexibility to negotiate the ground between long-term, strategic considerations, and short-term market aberrations.