InvestmentsApr 2 2020

Matching a fund to the risk profile of a client 

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Matching a fund to the risk profile of a client 

Picking the right fund is a complex process, and at the start there are many factors to take into account.

According to Darius McDermott, managing director of Chelsea Financial Services this can be a combination of the individual needs of a client, the necessity of diversification, and the relevance of the wider macroeconomic environment, making it far from straightforward.

He says: “But when you strip away a lot of the noise it generally boils down to three things, namely their investment timeframe; their risk vs. return profile (how much loss can they stomach to achieve their long-term investment goals); and whether they need growth or an income from their investments.

"Age and investable assets often fall into these three areas and form the central pillars of risk profiling.”

What does the client want to achieve?

This point was elaborated on by Gary Potter, who jointly runs a range of multi-manager funds at BMO Asset Management said the first consideration for a fund picker is the question of what the client wants to achieve.

He says once this is established, the job of the adviser is then to decide at what pace they want to achieve the goal.

Mr Potter says: “You could go at 30mph and get there, it will take longer but there is very little risk that you don’t make it.

"The alternative is to go at, say 80mph, and the likelihood is that the goal will be achieved much more quickly, though the risk of it going wrong and the goal not being achieved is also higher.

"If you are looking at which of those approaches to take, then clients' starting point, including their age, their time horizon and their capacity for loss are then the considerations. 

"More equity in a client's portfolio probably means more risk, while more bonds would traditionally mean less risk.”

Volatility vs risk

Alex Farlow, head of risk-based solutions at consultancy firm Square Mile Research, says that while the market generally tends to focus on how volatile an investment is, this misunderstands that the relevant risk for the client is that they fail to hit their investment objective.

He says the first consideration should be the maximum loss of capital that could occur in a fund in bad times, and the extent to which each client is in a position to handle this risk.

He adds that volatility is defined as the propensity for the price of an investment to move sharply up or down in price, but that this is not the same as risk. Mr Farlow said this is the key to aligning the interests of the client with those of the fund chosen.

As FTAdviser has previously reported, many market participants highlight that a key problem with the Mifid rules is they do treat volatility in the same way as they treat risk.

This comes from providers being required to place a risk number of between one and six on their fund, with one being the least risky and six being the most risky.

The measure required by regulators links the definition of volatility to risk, in a way that Mr Farlow thinks is a problem.

Charlie Parker, managing director at Abermarle Street Partners, a discretionary fund house, also highlights that mistaking volatility for risk is a major mistake made by fund buyers.

He says: “Up until three weeks ago, you could have looked at the IA Sterling Corporate Bond sector and thought it had no volatility at all and so is low risk.

"Then a few days ago it fell 4 per cent in a day.

"My view is you can’t really align the risk of a fund with a client’s level of risk, you have to do it at the portfolio level, where there is a greater balance between asset allocation and investment styles.”

Model portfolio services

Regulatory changes have led to a wider focus on costs and placed extra time pressures on advisers. 

This has led to an increase in the number of advisers using “one stop shop” investment solutions, such as model portfolio services or discretionary fund management providers. 

Ben Seager-Scott, head of multi-asset funds at wealth manager Tilney says: “If you’re going for a one-stop shop, such as a multi-asset fund, I’d suggest looking at the expected return profile of the fund with a close eye on metrics such as expected volatility and see whether these are in line with the client’s parameters.

"I’d also suggest looking at the asset allocation within the fund to identify the levels invested in relative high or low risk asset classes.

"If building a portfolio of single-strategy funds, I’d say it’s important to take a look at the portfolio overall, and that the mix in aggregate follows the same points as above.”

Tom Sparke, investment director at GDIM, a discretionary fund management firm in Cambridge, says he generally tries to combine what he thinks are higher risk funds with those that have a lower risk profile, in order to create a balance, with the end client then placed into the portfolio that most closely matches their objectives. 

He says that among the characteristics he examines to determine the risk level of a particular fund include the propensity of the fund to fall when the market falls, and the extent to which the fall matches, or exceeds, that of the market as a whole. 

Ben Willis, who runs the model portfolio service at advice firm Chase De Vere says: “Unless it is a multi-asset or multi-manager fund, such as one that will sit within the IA Mixed sectors, then we wouldn’t allocate just one fund to a client.

"Instead, we would construct a bespoke portfolio with a mix of diversified funds that matched the client’s attitude to risk.

"The portfolio could consist of higher risk and lower risk funds, just as long as the overall portfolio matches the client risk profile.”

Shane Balkham, chief investment officer at Model Portfolio provider Beaufort, says a useful way to understand a fund and the likely level of volatility in the short-term is to “pin” an investment style on it, and once you understand that, you have an idea of what the volatility may be like, as the style could be in or out of favour at any particular time.

david.thorpe@ft.com