Risk-rated, risk-targeted and the former Balanced Managed

The actual definition of the sector has changed little, but the renaming of the Active, Balanced and Cautious Managed sectors signifies an active attempt by the fund management trade body to distance itself from names which might suggest a certain level of risk.

It was often claimed, in the case of the IMA Balanced Managed sector, that a maximum 85 per cent weighting to equities was not exactly the dictionary definition of ‘balanced’.

But while the IMA has distanced itself from anything that might imply a guarantee or a level of risk – take the renaming of the Absolute Return sector last year, for example – other, more explicit forms of risk-rating have emerged in the past few years.

Companies such as eValue, Distribution Technology, Finametrica and Oxford Risk have all developed their own methods for ascertaining the ‘risk’ of a fund or the tolerance of an investor – sometimes both.

Only Distribution Technology publicly lists the funds it rates on its website. Of the several hundred funds and models rated by the company, 42 sit in the IMA Mixed Investment 40-85% Shares sector – just under a third of the 151 members of that sector. These are roughly evenly split between DT ratings ‘5’ and ‘6’, out of a range of ‘1’ to ‘10’ where ‘1’ is equivalent to cash.

Risk-rated or risk-targeted?

Of course it is important to distinguish between how the risk rating is applied in each case. In some cases – such as Aberdeen’s Multi-Manager Balanced Managed fund and Jupiter’s Merlin Balanced fund – the risk rating has been applied to a product that has been operating for some years and is meant to be used as a ‘snapshot’ of the fund’s potential level of volatility. It is not guaranteed and is liable to change.

So why do it? Invariably it is a question of adviser demand.

Scott Spencer, a portfolio manager on Aberdeen’s multi-manager range, says: “While our funds are not managed specifically to the Distribution Technology profiles, we took the decision to rate our multi-manager funds in order to help advisers when recommending our funds to their clients.

“The comfort that comes with an external confirmation of risk profiling is becoming increasingly important in this post-RDR world as advisers can feel more confident matching client risk profiles to fund solutions and focus more of their energies on financial planning.”

Similarly, Fidelity’s Multi-Asset range – run by Trevor Greetham – has Distribution Technology ratings. But a spokesperson for Fidelity explained that the ratings were applied as “illustrative guidance” for advisers and investors alongside Fidelity’s own risk models.

This means that Fidelity’s Multi-Asset Growth, Multi-Asset Allocator Growth and Multi-Asset Open Growth funds in the IMA Mixed Investment 40-85% Shares sector could potentially shift DT risk bands – although given that the funds follow their own risk models this is unlikely.

For some companies the addition of a DT rating can aid distribution. As Scott Goodsir – then BNY Mellon Asset Management’s director of UK wholesale – said last year on the news of several BNY Mellon, Newton and Insight funds gaining risk ratings from DT, the ratings are “more than just a badge”.

Mr Goodsir said: “A lot of the big networks use risk profiling questionnaires – SimplyBiz for example use Distribution Technology across the board – so it is good for us in terms of distribution.”

In other cases, however, a specific risk rating is targeted. This usually means investors can expect the fund to maintain a certain level of volatility. While these funds are typically left in the IMA’s Unclassified sector to avoid confusion with more flexible multi-asset or multi-manager products, several are listed in the IMA Mixed Investment 40-85% Shares sector.

These include Legal & General Investments’ recently-launched Multi-Index 5 and Multi-Index 6 funds and multi-manager specialist Momentum’s Factor 5 fund.

A spokesperson for L&G explains that the company decided to place its range within the IMA’s Mixed Investment sectors because it offers “familiarity” rather than “the greater ambiguity of the Specialist or Unclassified sectors”.

“Risk-rated funds that sit in a particular sector can have a narrower mandate than what is fully permitted by the sector,” L&G says. “This allows the fund to comfortably fit within the sector’s definition.”

The spokesperson adds: “Because the funds do not use the full flexibility of the IMA sector, nor seek to outperform the IMA peer group, peer group [performance] rankings do not have much meaning.

“The performance relative to the IMA sector’s average will be more of a function of how the risk profile performed against the sector average.”

While any conflict or clash which does emerge between a fund’s risk-rating and its place in the IMA sectors should be an issue for the fund managers to solve with their trade body, advisers should be wary of the scope for investor confusion.

What if, for example, an investor assumes that his fund has an 85 per cent weighting in equities while also being rated ‘5’ on the basis of its asset allocation or volatility? Such a position could raise some difficult questions for the adviser to answer.

Performance

The differences between the funds can also be seen in performance statistics. The top eight best-performing risk-rated funds over three years in the IMA Mixed Investment 40-85% Shares sector are rated only by a ‘snapshot’ of the portfolio. A total of 22 such products that have a three-year track record and together they posted an average return of 16.4 per cent.

Meanwhile, the nine risk-targeted funds in the sector with a three-year track record had an overall lower average return of 15.6 per cent. As explained by L&G’s comments, this is an indicator of the likely restrictions of funds which are truly risk-targeted.

Ultimately, whatever the nature of a fund’s risk-rating or its sector, the FCA will want to see evidence showing why an investment decision was made. The regulator’s 2011 paper on risk profiling tools made it clear that it was not sufficient for an adviser to rely on the tool’s output alone.

A risk rating or peer group definition is unlikely to cut the mustard when the regulator comes knocking.