This has been a response by product providers and the wider industry to provide a consistent investment approach that is affordable for clients and profitable for product providers and advisers.
In tandem with the rise of these products, has been the growth of the risk-profiling industry.
Several providers have emerged that study portfolios and funds to determine their risk profile, and question a client’s attitude to risk. By aligning these two elements, they offer a service for placing your clients in investments that are appropriate for their needs. However, the situation is somewhat more nuanced.
Measure
There is no agreement on how to measure risk and how this should be matched to an asset allocation. Therefore, we see differences in how funds and clients are risk profiled depending on which risk-profiling service is used. There is also the qualitative value that an adviser provides and how this can feed into the service. Finally, the kind of fund that is chosen is also important. I believe that the emergence of all these services and products is a positive development, however it is important advisers apply proper due diligence in choosing a risk profiling service and the consequent investments.
Before moving onto the details of risk profiling, it is important to cover why it is becoming such an important part of the advice process.
The former FSA’s Assessing Suitability paper, published in April 2012, talks about how important it is that a firm ensures that its clients’ investment portfolios match their risk profiles.
Given the need for a fund risk profile, we need to get our heads around what a risk profile is and, more importantly, what it is not. These kinds of ratings are not a guarantee of performance or capital security.
Generally, they are conducted by a risk-profiling company, which looks at the asset allocations and performance to ascertain an estimated volatility, with some even forecasting this over different time horizons. This process can be complex with risk-profiling companies using some proprietary methods and committees to determine risk profiles.
First, from the perspective of testing a risk profile, an adviser needs to recognise there are, generally speaking, three primary aspects to risk in this context:
Risk required – This is the risk associated with the required return needed by a client. If an investor needs to take on added risk in order to generate a required return, this needs to be taken account of and recorded. An adviser should also decide what to alter: the investment or the goal. For example, the client’s investment goals may be totally unrealistic in the given investment environment or risk tolerance.
Risk capacity – This is the extent to which returns can be worse than forecast without upsetting a client’s plans. This is accounting for the unexpected, such as a client outliving his assets, or a return ending up lower than expected and whether the client is able to withstand this. Advisers should model and stress test to account for these events.
Risk tolerance – This is a psychological factor that determines the amount of risk a client prefers to take in his investments, regardless of the above two factors. This can be determined by a risk-profiling questionnaire and is least variable of these factors.
Once a correct risk profile is established, advisers must survey the wide range of investment propositions to achieve their aims.
It is increasingly likely that this could be some kind of multi-asset solution. In the fund space there are two types of products emerging: risk-targeted funds and risk-profiled funds. Risk-targeted funds are designed to target a volatility level in line with a specific risk profile.
The second kind of funds is usually existing multi-asset funds with an established investment process, typically focused on a performance target rather than a risk target, which are then retrospectively risk rated.
For those funds that are designed to achieve a defined volatility target, their risk rating should provide a reasonable indicator of future volatility. However, 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 FCA guidelines outlined in the suitability paper. As they are managed primarily with performance in mind, their asset allocation is determined by return and this could lead to periods of both high and low volatility. This means there is less chance of them delivering a predictable risk outcome.
Relationships
It is clear that the risk profiling of clients and investment propositions is here to stay. If applied correctly it should allow for better relationships between advisers and clients.
However, because of the way the market is developing, there are potential pitfalls for advisers and I believe some vigilance is needed.
Fraser Blain is head of UK retail sales for Allianz Global Investors
Key points
- Post-RDR we have seen the rise of model portfolios and centralised investment propositions.
- These kinds of ratings are not a guarantee of performance or capital security.
- A key aspect of the risk profile is how advisers deal with the greater discussion about risk with clients.
Should risk profiling use the benefit of hindsight?
One of the central objections to much of the debate over the appropriateness of risk profiling is the use of historical data. Historical data is important to the risk-profiling process, however, some do debate its validity. In 2007/8 assets became much more correlated than historical data had forecasted. However, this dramatic increase in correlation was only experienced for a short period of time. Moreover, even during this difficult time, a multi-asset portfolio would still have provided more protection than a 100 per cent equity investment. There are several different ways to approach these problems with historical data:
- Some operate a ‘decay factor’ on data, so that more weighting is given to recent data over more distant data.
- Some might only look at short-term data at the expense of old.
Whichever methodology is used it is vital that both providers and advisers are aware of the nuances of each process, as maintaining a consistent risk profile in their products and for their clients is vital.
