This is present in all data services across our industry and occurs when the data vendor is unable to classify certain assets within the available asset classes, or the fund manager has provided insufficient information to classify those assets.
It’s not unusual to see allocations of 10 per cent or more to ‘other’ but Defaqto takes great care to understand the nature of these assets – exposure to fixed interest assets compared to equities would have a big impact on the expected future volatility and associated risk-rating.
We then undertake reviews on a quarterly basis to ensure managers are continuing to run their solutions in line with our earlier assessments.
Different risk-rated solutions
One thing to note here is, that advisers should not mix and match risk-rated solutions and risk schemes.
For example, if a fund is risk-rated as ‘5’ by Defaqto that will not equate to a risk profile ‘5’ on another provider's scale.
Our forward-looking volatility band for a risk profile ‘5’ is 8.3 per cent to 11.8 per cent with a target of 10.0 per cent.
A risk profile ‘5’ from another firm may have a band from 12 per cent to 14 per cent, so our risk-rated 5 will not align with the scheme from the other provider.
To return to the concept of blending solutions together at the same risk level, let’s look at two funds.
Both are risk-rated as ‘5’ (on our 1-10 scale). They both have very different asset allocations but they can produce similar projected volatilities, so are risk-rated at the same level.
However, they may actually behave very differently in various market conditions, despite delivering the same level of risk for the client.
As an example, I have taken two real funds that have the same Defaqto risk-rating and are therefore expected to deliver the same level of volatility, which the client has agreed to through an attitude to risk process.
The two funds have a different approach to their asset allocation, as shown below:
Net asset allocations | Fund A % | Fund B % |
Cash – (money market) | 4.4 | 0.2 |
UK Government Bonds | 1.9 | 3.8 |
UK Corporate Bonds | 7.9 | 20.8 |
UK Index Linked Bonds | 0.0 | 0.0 |
Global (ex-UK) Fixed Income | 13.7 | 28.8 |
Global Property | 1.5 | 0.0 |
UK Equity | 22.2 | 1.3 |
Europe (ex-UK) Equity | 7.4 | 20.1 |
North America Equity | 6.2 | 13.3 |
Japan Equity | 7.7 | 1.1 |
Dev Pacific (ex-Japan) Equity | 1.8 | 3.1 |
Emerging Markets Equity | 8.4 | 6.6 |
Absolute Return | 6.2 | 0.0 |
Other | 10.9 | 0.9 |
Total | 100.0 | 100.0 |
Source: Defaqto Engage to 17/6/19
Over the last three years they have a high correlation level of 0.92 per cent and have similar risk/return characteristics, as shown in the below table:
Fund | Annualised Volatility | Annualised Return |
A | 6.6% | 7.24% |
B | 6.5% | 7.48% |
Source: Morningstar Workstation 17/6/19
But, when we examine certain snapshots in time, we see very different behaviours.
While both funds delivered almost identical total return, for the period, the actual journeys were different.
Fund A performed well up until early 2018, with Fund B generally doing better until the end of Q1 2019.
So, combining the two funds within a portfolio would have delivered the same level of risk and return, but with a smoother ride in performance terms.
