InvestmentsJun 18 2014

Market View: Knowing the risks involved

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The fund industry is an ever-evolving beast; the party ground for marketing departments with ‘enhanced’ this, or ‘maximiser’ that.

The success or otherwise of these developments can be marked by their prevalence in today’s retail markets. 130/30 funds anyone?

Currently, the offering du jour seems to be the use of risk-rated funds, with every fund group clamouring for a number that they can wear with pride; a number upon which they can rest their laurels upon and for the advisory world to segment their client bank into.

I know a client who is a number 5, I’m sure there is a fund group which offers a number 5. Bingo, job done.

Like it or not, that is reality. Type answers into a questionnaire and you get a number linked to an asset allocation model, derived from the culmination of financial market performance in the past few decades. Depending upon the blend of said assets, you are given a number which it is said should correspond to a band of volatility from which the manager will maintain the fund. Subsequent investment performance should take into consideration the restrictions from which the risk target band demands.

From speaking with a number of managers who run these types of offerings, their rationale for managing a mandate based upon a risk target is obvious. Focusing on a risk target restricts the manager from taking on board too great a level of volatility and therefore protects clients from unsuitable capital drawdowns. In theory.

If selecting a manager isn’t the most difficult job, what about the ongoing analysis? The most simplistic way for advisers to evaluate performance is by looking at the risk target their chosen manager is aiming for.

As such, we can also propose that if this is the measure for original manager selection, it is therefore the most suitable and perhaps only method for ongoing evaluation.

So what if your fund is missing its self-imposed volatility band? Is it acceptable if it undershoots but not if it overshoots? Anecdotally, my discussions with fellow professionals indicate that taking too little risk is okay but taking too much is not, possibly due to the human propensity to perceive capital losses more keenly than capital gains.

However, the point still stands that the managers are failing to meet their targets and irrespective of the performance, the clients are at significant risk of not achieving their objectives.

Fundamentally, what we are moving away from is the traditional investment focus of return to the modern evaluation of risk, irrespective of the subsequent return.

I fear that the industry sees these funds as a panacea to the investor suitability issue. However, clients cannot spend standard deviation; risk will not pay for their daughter’s wedding.

I would go so far as to state that risk targets are being used as an excuse for poor performance, with the congregation being found within the IMA Unclassified sector, rendering broad sector attribution moot.

To conclude, a risk target means nothing. It is no indication for performance, nor is it a guarantee of appreciable maximum capital drawdowns. It is a crutch which underperforming managers can point to as justification of returns without the nuisance of peer comparison.

Andrew Alexander is head of investments and product strategy at Three Counties