Risk-rated funds are misleading: Needham

Speaking at the Morningstar Investment Conference in London, the chief investment officer at Morningstar Investment Management criticised the financial industry’s use of historical price volatility to measure risk and its overreliance on quantitative measures.

He said risk-rated funds looked at volatility to measure risk and warned those in attendance to avoid putting their clients into vehicles that ignored the importance of valuation and failed to consider other factors that could affect investment markets.

Mr Needham said: “Risk is a term used so much in the UK, but the terms are not defined. We have risk-rated funds and risk-profiled funds, which demonstrate how they risk profile investments by looking at volatility.

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“If volatility is your primary measure of risk, then you are in trouble. Our research shows real issues with using historical volatility as a measure of risk, so the fact it is used widely in our industry is puzzling.”

Instead, Mr Needham said research revealed that periods of high volatility were associated with the best buying opportunities.

Aside from an overreliance on quantitative analysis, Mr Needham also warned that risk-rated funds were ineffective because they sought to “industrialise a complex problem”, which he claimed just added more risk in the long run.

He also warned the industry to maintain a more open mind and compared investing to poker rather than roulette.

Mr Needham added: “In our industry, we love precision, but it creates this illusion of knowledge. Unfortunately, this is very dangerous. Feelings of certainty are false and incredibly dangerous.”

Adviser view

Robert Lockie, investment manager and branch principal for London-based Bloomsbury Financial Planning, said: “It is difficult to put human behaviour into a mechanical system and expect results every time. You cannot just pull out some questions, get some answers and say this is the right score for you.”