Investments 

Crisis era risk switching undermined DFM returns, says Arc

Discretionary management clients have suffered from switching risk profiles in reaction to the market, according to the latest research from Asset Risk Consultants (Arc).

Investors dived into risky investments in the build up to the financial crisis and missed out on the subsequent rally by swerving the other way into defensive portfolios, according to Arc’s survey of the past decade of discretionary management.

Arc, which collects data from roughly 50,000 different bespoke portfolios from 54 management firms, has analysed the returns from those portfolios in the past decade.

It found that the number of portfolios in its various risk categories, which vary from the more defensive Cautious up to Equity Risk at the highest level, varied depending on what investors had just experienced in the markets.

As a result, there was a huge increase in the number of equity risk portfolios in 2007 and 2008 in the build up to the financial crisis.

The Arc data then shows investors abandoning those risky portfolios and switching into Cautious or Balanced Asset portfolios throughout 2009 and 2010.

This meant that huge numbers of investors were in high risk portfolios when markets crashed and were in low risk portfolios when the markets rallied so failed to capture the full extent of the upside.

However, the most recent trend towards higher risk portfolios began in the middle of 2012, around the time that European Central Bank president Mario Draghi precipitated an extended market rally by pledging to do “whatever it takes” to save the eurozone.

That the increase in risky portfolios has broadly moved in line with the rally rather than reacting late and missing out appears to be a rare occurrence based on Arc’s data.

The consultancy firm said that the proportion of portfolios spread across its four risk categories is now back to roughly the same as it was a decade ago.

However, the firm added: “The worry is that the path suggests that private client and charity investors have not learned the lessons of the past and tend to reduce portfolio risk after experiencing losses and increase portfolio risk after a period of equity market buoyancy.”

While discretionary managers manage clients’ money independently from any input from the client, the choice of risk level in the fund comes down to the clients’ own preference in conversations with the DFM or with their adviser.

So it is unclear how much of the reactive investment philosophy demonstrated by the Arc data is down to the client or the manager.

Arc said that the movement towards defensive portfolios in 2009 and 2010 happened because “investment managers and their clients sought to come to terms with the implications of the financial crisis”, suggesting it was a combination of the two.