It makes sense that end savers are invested in products that align well with their risk profile and knowledge of investing.
A risk profile is perhaps the single-biggest determinant of any advised client’s long-term returns because it generally maps to a long-term asset allocation.
We also find that the providers of risk-profiling software (and scores) can supply underlying asset allocation services, creating a seamless process from the client’s initial risk score to their final asset allocation.
Investment managers respond to this risk-banding phenomenon by creating funds and model portfolios that neatly match risk-profile scores. But because client risk profiles tend to be long term in nature and asset allocation is dynamic, it is challenging for investment managers to stay within those bands.
Quite recently we have seen funds and model portfolios managed according to volatility bands to overcome this challenge.
Fund managers could stay within a volatility channel while doing active asset allocation, thereby tying their fund or model to a definition of risk that was fairly consistent.
For advisers and clients, there are benefits of using volatility-banded investment strategies that link to risk-profiling scores created by the software vendors. For example, there is unlikely to be ‘risk drift’ away from the risk a client has indicated that they would be comfortable taking.
The end client will also be able to take a long-term view, rather than having to switch investments if asset allocation drifts too much.
Clients can also, in theory, have a clearer understanding of what the likely long-term risks of the strategy are, like the potential loss, recovery periods and the time horizon needed to achieve their risk and return goals. However, there are also potential negative consequences, and these worry us.
The main risk, as we see it, is that investment managers may have incentives that contradict their better judgement.
For example, most fund managers will tell you that volatility is not always a proxy for risk, and they would be right. Yet volatility bands see risk as just that.
If a more sensible definition of risk is suffering a permanent loss of capital, then avoiding overpriced and popular assets would be a prudent strategy.
Intuitively, we know that volatility spikes when assets become cheaper and softens when prices climb. This should draw us into high volatility, rather than encourage us to sell assets that have gone down a lot.
Yet, a volatility-managed strategy may create the opposite effect: buying the popular, low-volatility assets that are going up in price and selling the oversold, more volatile assets that are causing breaches to the bands.
Staying within the risk-profiler’s bands may also become the overriding investment objective of the fund manager because straying from it may cause clients in that risk profile to sell their fund.