The value of investment management association sectors has long been contentious, but it hit the headlines again earlier in the summer when several advisers, including Rayner Spencer Mills, suggested the current sectors were no longer suitable for advisers’ needs.
However, it is difficult to change the habits of the industry: the IMA sectors are known quantities, and have for a long time been widely favoured as a standard for grouping together similar funds. So what could we replace them with, and are there any other methods already used in the industry that could be adopted to better measure how similar funds really are?
There are several alternative measures to IMA sectors. These include risk-based systems such as Defaqto, Distribution Technology and Finametrica. Other measures could include the consistency of a fund’s management style, ongoing charges, the maximum drawdown and standard deviation. Risk-rated solutions do stand out as an effective and feasible alternative to IMA sectors.
Several large investment companies have already adopted a risk-based approach on some of their funds. Henderson, for instance, uses Distribution Technology on its Core Multi-Asset solutions range and the Old Mutual Spectrum Fund, which uses a risk-based approach and is unclassified by the IMA. Smaller fund houses are limited in their reach and distribution, not to mention their marketing budgets, which are unlikely to be as far-ranging as those of a firm like Henderson’s, so they may find it harder to get people to invest in any of their funds which are unclassified by the IMA.
Despite this, investment houses can take steps to make investors more open to putting their money into one of these funds.
However, these approaches still do not cover all eventualities. For instance, while investors with a similar risk profile are likely to require similar solutions, it is not clear what the most efficient way of deciding this would be. Also, establishing IMA sectors according to risk profiles may be a desirable approach, but is risk the only factor that investors need to consider?
Another issue is that many risk-rated funds have suffered from poor performance, and some investors have been railroaded into the wrong assets at the wrong time in order to satisfy their risk criteria. If we take a simple example in which a risk-targeted process might dictate that a client with a three out of 10 risk appetite should have 25 per cent of assets allocated to sovereign debt. The problem with taking such a simplistic systematic approach is that, while advisers might want to take a consistent approach, they might feel uneasy about piling money into gilts at that particular time. For instance, should interest rates be rising, this particular asset class would not perform as well. So does this mean they should ignore their own process and focus on a different asset? If so, on what basis? And what is the most effective way of judging what should be the precise trigger for this ‘off process’ approach to matching investments to a client’s needs?
A better approach could be to adopt a process in which risk requirement is still clear, but the interpretation at any given time by the asset allocator is dynamic. Here, the risk of an asset can be continually assessed and the investment mandate for each given level of risk can vary according to market conditions (albeit within strategic asset allocation parameters). This avoids the trap of knowingly or otherwise driving clients into assets that appear not to be suitable just because of the historic behaviour of assets. But do not long-term assets returns revert to their long-term mean in any case? Well, that may well be true – but how many clients are happy to ride out a theoretical experiment which might take 20 or more years to be proven correct? It is reasonable to assume that most advisers will believe achieving client objectives are more important than proving this theory or that.
The role of the dynamic asset allocator then is either performed by the adviser themselves or, increasingly, a DFM. The assessment of client requirement for risk is the adviser’s role.
Perhaps the key to all this is really getting to understand the client’s goals. Without a broad understanding of a client’s current situation, their resources and their objectives, all attempts to match a risk-rated solution to a client are doomed to failure, or at least potential disappointment.
This is where the investment professionals could learn from the financial planning people. Too many investment managers will bang on about investment matters in some sort of vacuum without reference to client needs. It is only by applying the investment solution to real-life goals that we can get better at matching investment risks to individuals. At the same time though, the financial planning community might be better placed to focus on financial planning rather than investment matters. Many advisers we speak to have lots of demands on their time and don’t always have the resource to support investment research or the discretionary permissions which are increasingly needed to deliver a scalable business model.
The trend to outsource to DFMs means advisers can really focus their time on understanding their clients’ requirements for risk. The conversation between the adviser and the DFM is where the assessment of funds and their risks comes into play. The adviser should dictate the required level of risk while expecting the DFM to do the detailed work on which funds deliver to the adviser’s requirements. The quality of this conversation and the process that supports it can deliver strong results for the client. While there are detractors from this model, the big fund sellers will want to keep advisers keen to pick funds, and this model has served them well.
But whatever fund classification the industry develops will not be a short cut to understanding what is under the bonnet. A client will (and should) expect that the fund they invest in has been properly researched. It will never be good enough to say it was fifth in its peer group, or that it has won awards for the research house. A more fundamental assessment needs to be carried out on each fund selected to ensure it meets the client’s risk requirements. There have been enough examples in previous years for us to have learned this lesson well enough.
Lawrence Cook, director of business development and marketing, Thesis
