Risks involved in outsourced options

This article is part of
Discretionary Fund Management - July 2015

A feature of the post-RDR landscape has been the greater market share taken by outsourced investment solutions, whether multi-asset funds or platform-based portfolios.

Much of this growth has gone into solutions that take into consideration the risk being taken within a fund or investment portfolio.

In order to achieve a risk rating, the level of risk in the fund or portfolio will have been assessed, usually by one of the risk-profile companies, and formally aligned to their risk-profile tools.

Article continues after advert

Companies such as Distribution Technology or FinaMetrica will review the funds to ensure the alignment remains in place. Risk-profiling companies adopt different approaches and express their outputs using different scales, so their ratings are not comparable.

For a multi-asset fund, a common approach is to estimate the expected volatility of each asset class (or the main ones) using either historical volatility exhibited over a significant period – sometimes 15 years or more – or scenario modelling, projecting the volatility of each asset class in a number of future scenarios.

Let us assume the adviser has followed their preferred process, a questionnaire has been completed, capacity for loss assessed, and the adviser and client have had a detailed discussion on the risks and range of possible outcomes. Should the adviser recommend a risk-rated or a risk-targeted solution?

Risk rated

The term ‘risk rated’ applies to many funds and simply demonstrates that a vehicle has gone through a rating process. It provides an indication of the expected risk in the fund at the date of the review. Within a list of risk-rated funds, such as those risk-profile funds on the Distribution Technology website, many multi-asset funds can be found that either sit within Investment Association sectors or target specific investment objectives.

If the priority is performance benchmarked by an index, then an adviser might well choose a risk-rated fund. But the manager of a risk-rated fund has no commitment to retain the risk at the current level.

Risk targeted

Risk targeted, on the other hand, demonstrates a commitment by the manager to remain within a risk band or below an upper-risk limit of their fund. Although the risk-targeted category is quite broad, some funds have the clear priority of managing within a tight risk corridor with investment objectives taking a lower priority. Meanwhile, other managers aim to deliver, say, retail price index-plus returns while also ensuring their funds do not exceed volatility limits.

In general, an adviser searching for a fund with a risk constraint should start the search with vehicles listed on Defaqto’s risk-targeted multi-asset fund or FE Analytics’ risk-targeted multi-asset solution lists.

Distribution Technology also provides two lists: risk-profiled funds and portfolios and risk-target managed funds. In spite of the names used, risk-targeted funds could appear in either list. Therefore the adviser should ensure they carefully review the details of the underlying funds when making their selections.