Redefining risk

A flurry of risk-targeted and risk-managed funds have been launched in response to both of these trends, but it is harder than it might first appear for advisers to make use of them responsibly and successfully.

Funds which target risk and performance within a multi-asset framework have caused issues of categorisation both for the advisers they are supposed to help and for the wider market, as it becomes increasingly difficult to compare apples with pears.

There are two ways in which we need to look at risk measurement and classifying funds: forward looking and backward looking.

Article continues after advert

By forward looking we are referring to the suitability of a portfolio for an individual investor. This is more challenging than it might seem: the major problem is in defining the risk buckets in the first place.

We could use asset class composition; that is, make forecasts of asset class behaviours and project their future correlations, building a portfolio of funds investing in the relevant asset classes in the relevant mix.

This is the traditional method of building a multi-asset portfolio, but it is a very simplistic and flawed approach.

Chiefly this is because asset classes’ past behaviour is not necessarily a good guide to the future: the most obvious example of this is in the bond market, where many analysts warn that the future could see fixed interest struggle to gain in price terms after a 30-year bull market. On top of this, there are the fears of a coinciding fall of equities and bonds, as the US Federal Reserve withdraws QE to contend with.

As well as this, the variation of the volatility of funds within asset classes is itself huge. In UK equities, for instance, the highest volatility fund is twice as volatile as the lowest.

This means that if you build a model with a UK equity bucket, say 60 per cent, then the funds you could put in that equity bucket will have widely different risk profiles, making your original model a very poor guide to the portfolio’s performance.

Alternatively, you could use the historic volatility of the funds themselves to build models. But  this is dangerous, not least because volatility can change over time as funds go through different market conditions and as the asset classes they invest in develop.

Within the risk-targeted universe, the problem is compounded by the relatively short performance histories of most options.

Given that most funds have been launched into a bull market, albeit one that seems to have calmed in recent months, the historical data gives us no idea of how these funds might hold up in more stressful conditions.

In short, no approach is entirely suitable. It is important to realise that each product range is designed differently, and that each fund provider has a duty to assist the adviser in the selection of the appropriate product within a family to match the investor’s goals.

A risk questionnaire can help advisers in choosing a suitable product to meet their client’s goals, and explain the risks and the gaps in their expectations. However, it is not a replacement for the role of the adviser.