As part of this they will undergo a lengthy process of discovery with the client, looking at their goals and determining their attitude to risk and capacity to accept losses.
One of the main outputs from this will be a risk score for the client, often on a scale of one to 10 or one to 100, with a higher number indicating a greater tolerance of risk. The task of the adviser is then to provide an appropriate solution based on this measure.
Checking suitability
When considering investment solutions, many advisers will look at collective investment schemes and specifically multi-asset funds.
But how can the adviser be sure that a particular multi-asset fund is suitable for their client from a risk point of view?
As well as the new Volatility Managed sector the IA has four different sectors for multi-asset funds:
- Mixed Investment 0-35% Shares
- Mixed Investment 20-60% Shares
- Mixed Investment 40-85% Shares
- Flexible Investment
These give some indication to an adviser as to how risky a multi-asset fund might be; however, there can still be a great deal of dispersion within a sector.
For example, within Mixed Investment 20-60% Shares one fund could hold 25 per cent in equities, while another could contain 55 per cent, and these would almost certainly give very different outcomes in terms of risk and return.
Another way of determining the risk and therefore suitability of a fund might be to look at the fund’s name.
The Financial Conduct Authority (FCA), however, expressed concerns relatively recently over relying on fund names alone as a guide to how the fund might behave, due to inconsistency - e.g. what one provider says is cautious, another might describe as defensive.
Instead, the FCA expects the adviser to dig much deeper or rely on independent firms with greater experience and resource in this area to help them do so.
As a result a handful of firms, including Defaqto, have launched risk ratings for funds, primarily multi-asset, over the last few years. These give the fund a rating, usually from one to 10, based on its volatility.
Defaqto’s Risk Ratings are reached by:
- looking at the fund’s past volatility (standard deviation) of returns over one, three, five and 10 years, where that data exists.
- looking at the fund’s projected volatility using its asset allocation, both strategic (long term) and tactical (current), together with assumptions for the future returns, volatilities and co-movements of the asset classes it holds.
- discussing these numbers with the manager of the fund, which gives us the chance to consider other factors, such as a manager or mandate change during the life of the fund, which the numbers alone might not capture.
