Unwrapping risk targeted and return focused funds

There are several ways of offering managed solutions, including discretionary fund management (DFM) services and model portfolios, while many advisers will select multi-manager funds. We are focusing here on risk-targeted funds and return-focused funds.

Most advisers will assess two main options when looking to outsource some, or all, of their investment proposition – DFMs and managed funds. We acknowledge there are other solutions, but our research shows that these are the key areas.

Within managed funds, multi-managers come in numerous guises. Risk-targeted is where fund families are designed to provide clear and consistent gradations of risk and return where a risk measurement, generally volatility, has to be adhered to. Periodic rebalancing in line with the intended risk profile of a fund is often also a feature.

Return-focused funds seek primarily to generate returns either absolute or in excess of a benchmark or peer group. This is not to say that risk management is not a core component of return-focused funds, but they generally do not have an overt measure or number to adhere to.

Funds of funds invest assets in other collective funds to utilise expertise of specialist managers in each asset class; manager of manager funds outsource the running of segregated pools of assets to specialist managers in each asset class; traditional asset funds invest in traditional asset classes and long-only holdings; multi-asset funds also invest in alternative assets, including commodities and hedge fund strategies; active funds seek to generate returns in excess of stated benchmarks or indices; passive funds are underlying funds that do not actively buy and sell securities (although periodic rebalancing back to index weightings will take place); and blend funds hold significant positions in both active and passive funds.

There are two core aspects for advisers to consider when selecting funds:

• Fund performance

• Competitiveness in other key areas

It is relatively easy to do a high-level assessment of a multi-manager’s performance against a sector average. However, risk-targeted fund families are spread across six IMA sectors including Unclassified. To combat this, Defaqto has created a synthetic universe of funds to allow a formulaic comparison of the efficiency and success of fund families in offering the gradations of risk and return that they are marketed as aiming to do.

In terms of qualitative aspects, there are several key areas advisers should consider:

• Organisational scale

• Manager longevity

• Performance

• Asset allocation method

• Distribution

• Access

• Cost

Defaqto’s Diamond Ratings help advisers and their clients identify where managed funds sit in the market.

Diamond Ratings give each fund (and share class, where relevant) a rating of one to five based on fund performance – using the established QuantRater methodology and Sharpe Ratio, for return focused funds – and a range of other key attributes.

Initially, Diamond Ratings will assess the following types of managed funds:

• Multi-manager funds across four IMA sectors – Mixed Investment 0-35% Shares, Mixed Investment 20-60% Shares, Mixed Investment 40-85% Shares, and Flexible Investment

• Directly invested managed funds across those sectors

• Risk-targeted fund families

• Unitised DFM funds

There are few right or wrong answers, and different clients and advisers will have different needs and beliefs. However, as a starting point, it is important for advisers to assess the needs of their business and, ultimately, the needs of their clients so that they know exactly what kind of fund will be able to meet both sets of requirements.

David Cartwright is head of Insight at Defaqto