Looking under the risk-rating bonnet

One argument to support this trend is that most multi-manager funds are risk-rated currently and on the face of it seem to offer the answer to many an adviser’s prayers, namely access to and delivery of an off the peg solution for clients who have been profiled for risk. I would take issue with this idea as being fundamentally flawed and my reasoning is based upon a number of key considerations as follows.

Just so we are clear about what we are talking about, risk rated funds are tasked with the mandate of outperforming a benchmark, but have to achieve the returns within a clearly stated risk corridor which is itself measured through close attention to standard deviation. For most clients this is way too complex to understand and also may present a significant challenge to many advisers to evaluate. It is all very well to measure against a benchmark but who is in fact setting this, the marketplace sector average for example, or is it simply that as determined by the investment provider against the performance of its own funds? It is important to consider fund of funds as part of this equation too and the choice between fettered and unfettered fund offerings and their relative value and contribution to risk diversification within a portfolio.

Risk rating has been with us in some shape or form for many years; historically a fund provider could simply pay for one of the proprietary agencies to use their star rating in their marketing but to the end user, the client, this was pretty meaningless and certainly no assurance of the fundamental quality of the fund or its investment management team. There are a number of drawbacks inherent in over reliance upon outsourcing investment decisions and portfolio planning to third parties such as multi-management, not least whether there is too much emphasis on volatility, and not other forms of risk, as well as playing down the importance of performance and other factors.

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There are numerous factors that create risk for investment; interest rates, inflation, political uncertainty, currency/exchange rates, liquidity in markets, stock volatility, investor and economic confidence and general sentiment; investment philosophy and the capabilities and skills of the fund manager are just some of the key considerations.

Since the start of 2013 and RDR implementation, the world of investment advice has become increasingly focused on investment risk. This covers a huge area of knowledge and skills but for the investment adviser, the main show in town is currently all about client attitude to risk, with the new regulator, the Financial Conduct Authority, continuing the drive started by the Financial Services Authority to raise the standards and process involved with understanding and establishing risk in investment advice given to clients

This is of course an essential part of the client relationship cycle but I believe there exists however a huge problem for trying to make the demonstrable or provable link between “risk profiling” and ultimate selection of a multi-manager fund to invest the client’s money in. The various “attitude to risk” (ATR) profiling tools that are available only go so far in the process, relying heavily upon a series of sometimes bizarre and fatuous questions for the client, the answers to which are then “analysed” to produce a risk profile. Unfortunately, all of the tools I have looked at to date miss a number of key points and considerations, simply leading the client down a path ending up strangely enough with some sort of balanced risk – now where have I heard that before?