Multi-managerAug 21 2013

Looking under the risk-rating bonnet

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by

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.

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?

How then do we use the output from these ATR profile tools to identify a suitable match with a multi-manager or fund of funds? The challenge facing advisers and their clients is to identify or perhaps have to design one that does actually manage to take on board the clients’ individual appetite for risk and reward – I suggest this is yet be achieved, if indeed it is possible to do this with a processed system driven approach rather than detailed Q&A as part of the fact-finding process. One key area of the risk conversation very close to the heart of the regulator is that of Capacity for Loss and what the client understands by this and where they sit on the curve of being aware of the potential downside and financial consequences therein.

Over reliance on risk ratings, however they are derived, can artificially skew advice and potentially ignore other key factors like active or passively run funds, underlying costs and charges, asset allocation and diversification and also the availability of access to the fund in an increasingly platform-driven marketplace.

Consider the performance over five years of five of the top performing multi-manager or fund of fund offerings in the global equities sector for example. The names have been removed to avoid the subjectivity of reading brand names rather than the performance.

Fund managerFive year total return
Fund A41.3%
Fund B37.8%
Fund C35.8%
Fund D34.3%
Fund E34.68%
Sector Average29.1%

Source: Lipper. Performance up to 31 May

Were we to now apply a risk rating to these funds the picture would look like this:

Fund managerFive year total returnFE Risk score
Fund A

41.3%

75
Fund B37.8 %86
Fund C35.8%84
Fund D34.3%85
Fund E34.6886
Sector Average29.159

So does the added input of a risk rating actually make a compelling contribution to help advisers when selecting multi-mananger funds or indeed any funds? The use of a third party risk assessment within the due diligence of investment fund selection needs very careful consideration, otherwise I suggest that the potential for reverse engineering when designing a portfolio could create problems, particularly in relation to independence of advice.

It is worth noting when looking at the above fund returns that over the same period, while the sector average return was modest at 29.1 per cent and less than the funds shown in the tables above, the growth of the FTSE World 43.6 per cent.

Would the application of the risk ratings have been a limiting factor in the portfolio or would they be used as part of the rationale behind the fund selection and articulated as a value adder on the fund research and due diligence side?

So what do we conclude from this? The answer is pretty obvious, namely that risk ratings can be a constituent element of an investment research process but they can only add value when all the other risk factors have been taken on board and evaluated when considering a fund. All investment advisers have their own particular views on how to approach fund selection and asset allocation for their client portfolios, this is for many people the differentiator that marks them out from their competitors and may form the USP for their own business.

More questions raised than answers given but very thought-provoking and should galvanise the thinking of advisers who are trying to evaluate the relative pros and cons of risk scoring and rating of funds in the multi-manager and fund of fund area, a sector now becoming perhaps more correctly referred to as flexible investment sector?

Nick McBreen is an IFA at Worldwide Financial Planning

Key Points

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

There are numerous factors that create risk for investment; interest rates, inflation, political uncertainty, currency/exchange rates

Risk ratings can be a constituent element of an investment research process but they can only add value when all the other risk factors have been taken on board