How to evaluate risk and volatility

But what do these words mean in the context of choosing the right multi-asset fund for clients?

Understanding the investment philosophy and strategy of the manager is key to understanding how risk will be taken and how it will be managed, according to Mike Coop, head of multi-asset portfolio management at Morningstar Investment Management.

Generally, advisers will choose a multi-asset fund having already established their clients’ appetite for risk and capacity for volatility.

Guilhem Savry, head of global macro and dynamic asset allocation, cross asset solutions at Unigestion, explains: “We believe that the risk investors are concerned with is capital loss, not fluctuations around the average. 

“As a result, risk is about more than just volatility.”

He says Unigestion’s own proprietary risk measure is based on expected shortfall and accounts for “skewness”, tail risk and liquidity risk.

Too simplistic

Advisers might assume that a multi-asset fund, which is invested across asset classes, is better at spreading risk. Is this the case?

“Being diversified offers real advantages to spread the portfolio risk because it lowers the dependency on a few sources of return – quite often equities,” Mr Savry suggests. 

“Of course, assessing gross risk is important to ensure that you are not overly reliant on correlation assumptions and properly understand the amount of capital you have on the table.”

Given that unexpected and unplanned-for volatility can have a significant impact on a client’s investment journey, Will McIntosh-Whyte, assistant fund manager of Rathbones' Multi-Asset Portfolio Funds, agrees that looking at volatility alone is too simplistic, “as low volatility does not equal low risk”. 

He continues: “Too often, risk is hidden by low volatility, driven by poor price capture, subjective pricing and modelling, infrequent valuations, or a combination of them all. Forecasting drawdowns is a better way of analysing actual risk.”

Mr McIntosh-Whyte confirms: “Setting clear expectations for clients around volatility is incredibly important – we operate a risk budget for each to try and set expectations for clients as to how they each may behave in tougher times for risk assets.

“Relative volatility risk budgets make most sense, as these allow us to manage the funds more effectively during more volatile markets – an absolute volatility target can drive a manager to have to make changes (ie reduce risk into falling markets) to stay within it as equity volatility increases.”

Minesh Patel, chartered financial planner at EA Financial Solutions, warns that unplanned volatility can be damaging and alarming for clients in cases where adequate reserves have not been maintained.

This might affect some clients more than others, depending on how far along the investment journey they are.

“This is particularly relevant during decumulation in the early years where income needs are being met, which highlights the importance of cash flow modelling in addition to an appropriately diversified risk matched portfolio,” he says.

Analyse and assess

What can advisers do to more accurately measure risk and expected volatility in a fund before assessing whether it is right for clients?

Mr Patel suggests: “Advisers can use statistical measures of risk and volatility such as Alpha, Beta, Sharpe ratio and standard deviation. 

“Multi-asset funds vary in comparison to one another – for example, passive and active multi-asset fund versions. 

“The importance of the statistical measures are to ensure suitability against client-agreed risk profiles and capacity for loss.”

Mr Coop acknowledges: “Advisers should look out for managers who favour assets that offer better value, focus on fundamental research to identify risks of a fall in cash flows, and hold assets which have different drivers of risk and return.”

For Ben Seager-Scott, chief investment strategist at Tilney Group: “Most multi-asset funds should be able to provide some level of analysis comparing risk and return over different time periods, and this can be used to assess risk-adjusted return – I’d suggest both volatility and drawdown are useful metrics for risk.”

He notes: “A qualitative assessment of a portfolio can also be informative to see which types of assets are included and how their correlations might change over time – for example, the correlation between equities and core sovereign bonds can fluctuate with the market cycle.”

eleanor.duncan@ft.com