However, despite similar risk ratings being awarded to these funds, they can actually be very different to one another. Advisers need to be aware of these differences and what they mean otherwise it could lead to some unpleasant surprises.
Suitability
Since the publication of the FSA Assessing Suitability paper, risk profiling of clients and products has become a key focus for advisers. The paper talks about how important it is that a firm ensures that its clients’ investment portfolios match the risk profiles, generated by any risk-profiling tool that advisers may use.
Therefore, if a client is deemed to have a low tolerance or capacity for risk, their investment portfolio must be low risk. The firm also has to show a clear audit trail of how they arrived at these conclusions and prove the investment portfolio is low risk, as well as ensuring the process is repeatable across its whole client base.
Such work from the FSA is leading the way globally in protecting clients by looking at such matters.
Many advisers have already taken this on board and are working hard to ensure their process is robust enough to stand regulatory scrutiny. This action from the FSA has led to product providers moving to fill the gap with a solution. Fund houses have realised that from now on they need to demonstrate the risk level of their products to advisers and how these products fit within different client risk levels.
Therefore we have seen a spate of new launches and fund rebrands to fit within this new regulatory framework. However, many of these funds may not be what they seem. I believe a pattern is emerging for two different types of risk rating multi-asset funds.
First, there are those that are specifically designed to target a volatility level in line with an explicit risk profile. For these funds, it is embedded within their investment process to meet this volatility target by altering their asset allocation to ensure they maintain a consistent and predictable volatility level, while also generating good returns.
The second type are those that have been ‘retro-risk rated’. These products are usually legacy multi-asset funds with an established investment process, typically focused on a performance target rather than a risk target.
As most current risk-profiling methodologies are mainly historic, these two kinds of funds may appear to have similar levels of volatility. This type of risk rating is no more than a snapshot of a fund’s volatility and is not an indicator of future volatility. For the first type of funds - those funds that have been designed to achieve a defined volatility target - their risk rating should provide a reasonable indicator of future volatility.
However, the second type - those that are retro-risk rated - could pose problems for advisers. While these products are often very successful and deliver good returns they do not fit well with the FSA assessing suitability paper’s guidelines. As they are managed primarily with performance in mind, their asset allocation is determined primarily by return and not volatility; this could lead to periods of both high and low volatility.
This means there is less chance of them delivering predictable levels of risk. For advisers that are selecting funds using risk profiles to match to their client’s corresponding risk profile, this could have significant ramifications. Not least it raises the spectre of advisers having to regularly re-advise clients should these funds move across different risk categories and the responsibility for this will fall on the shoulders of advisers.
Financial advisers find themselves under increasing pressure as the RDR approaches to meet the needs of their clients across the fee/service proposition.
I understand that risk-rated products can and will play a big role here but it is important that some caution is applied.
While it is very welcome that advisers have a new focus on risk, they need to understand that while retrospectively risk-rated legacy funds may look like target risk funds they are fundamentally different.
Not all funds that are risk rated are alike. I would advise that when selecting funds, advisers go through a rigorous due diligence process in understanding what is going on beneath the bonnet of the products they select for their clients; will these funds continue to achieve a predictable and consistent risk profile? I would suggest advisers should seek robust assurances from asset managers that the volatility of their products will not fluctuate wildly.
Should advisers choose to place their clients into investment products that exhibit unacceptable levels of volatility despite similar risk ratings, they could be held responsible.
With these developments, it is becoming increasingly urgent for advisers to be able to easily differentiate between retro-risk rated funds and funds that have been constructed and managed to deliver consistent levels of volatility. There is a risk that if this confusion persists, advisers may inadvertently be placing clients in funds that have very different risk characteristics to what they and their clients expect. Either advisers need to re-assess each fund their clients’ hold and their client risk profiles on a regular basis, and make the necessary adjustments, or choose funds that have been designed from the ground up with volatility targeting in mind. At a time when many clients are becoming more risk averse and advisers themselves want to ‘de-risk’ their own businesses as regulation becomes more focused on suitability issues, well managed, target risk multi-asset funds may provide a real solution.
Nick Smith is managing director of Allianz Global Investors
Retrospective risk-rating
Research was conducted recently to see if advisers should be concerned about retrospective risk-rating. The review, by a leading UK risk profiler, looked at funds with a risk profile of five and six, two of the most popular profiles. The findings showed that legacy multi-asset funds to which a retrospective risk rating had been applied did in fact have a greater range of volatility over a three-year period as compared to bona fide target risk funds (see fig 1 and 2, page 26). In one case a retro-spectively risk-rated multi-asset fund (risk profile 6) had volatility ranging from a low of 8.3 to a high of 15.3.
