Risk-rated or risk-targeted? Multi-asset investment
Risk-rated or risk-targeted multi-asset funds? What’s the difference and why is it important? David Holloway, marketing director for Rathbone Unit Trust Management explains
Risk rated funds
“Instead of defining the sectors by risk ranges, they continue to be defined by underlying asset exposures which are so broad that almost any outcome is possible.”
Risk targeted funds
“Risk-targeted funds are dynamic in approach. The ‘target’ offers an explicit measure of the risk that the fund manager is prepared to take.”
Much has been written about the need to gauge the individual’s capacity for capital loss and to consider what time frame should be involved. Risk profiling can then follow and advisers have an increasing number of tools to help catch and tame this herd of cats. However, matching them to a risk-rated fund will deliver a very different experience from matching to a risk-targeted one. The industry, even in its classification of multi-asset products, is struggling with the distinction and the reasons why it is important.
After selection, and crucial to continued suitability, is what ongoing monitoring is in place and how effective it is as time and client circumstances change. In response, intermediaries are outsourcing investment propositions as they seek to compensate for their own perceived gaps in expertise and instead to focus on more holistic financial planning. Obvious beneficiaries include discretionary fund managers, as well as multi-asset managers.
Added to this is pressure from regulators, compelling intermediaries to ensure client objectives are being met, not just initially, but on an on-going basis.
So what is the difference between risk-rated and risk-targeted funds and why is it important?
Essentially, risk- rated funds offer a snapshot of risk that is attributed to the fund. This does not assume that the investment process or objective embeds a risk measure.
The risk that an investor takes, therefore, is in buying a fund that addresses the risk at a specific point in time, and one that is not reflective of the level of risk that a fund manager might take in future, querying its ongoing suitability. The idea of controlling risk through the amount of exposure to equities alone makes no sense and therefore nor do the labels placed on managed fund classifications in the industry, supposedly representing three levels of risk exposure (Mixed Investment 0-35% Shares; Mixed Investment 20-60% Shares and Mixed Investment 40-85% Shares). The point is that investors need to look closely at a fund’s objectives and targets to really understand what they are getting. Instead of defining the sectors by risk ranges, they continue to be defined by underlying asset exposures that are so broad almost any outcome is possible.
Whereas risk-rated funds view risk, and all its influences, as static, risk-targeted funds are dynamic in approach. The target offers an explicit measure of the risk that the fund manager is prepared to take. This does not guarantee that capital cannot be lost, but it does commit the fund manager to working within certain parameters. For this reason, we see risk-targeted funds assuming a greater importance over the next 10 years or so.
For example, at Rathbones, our three multi-asset products are risk-targeted in the sense that they have relative risk benchmarks of one third, two thirds and 100% world equity market volatility respectively. With client needs paramount, these measures operate alongside return targets that will have some tangible meaning for the client such as a percentage over cash deposit returns (or cash- plus) or a percentage over inflation (long-term equity market return).
The tools of the trade
The Rathbones multi-asset funds are rated by Distribution Technology which involves a combination of past, present and future (expectations) analysis, both quantitative and qualitative. The ratings represent risk tolerances within which the manager is expected to manage the funds and these tolerances align with the fund objectives and risk targeting. They are monitored on a quarterly basis to help give advisers some assurance as to the risk consistency of product.
Most current risk-rated tools do not take time horizon into account, despite being such an important part of understanding the risks involved in meeting clients’ goals.
The flexibility to adapt to changing risks over a 20-year time horizon could mean the difference between short-term volatility, with the possibility of losses, to the destruction of wealth.
The industry is still hampered by the slavish use of historic, stochastic models as risk-profiling tools. This is reasonable if there is a 20-year time horizon involved but, by and large, they ignore the build-up of events that can drive a significant change in the value of an asset class. Ultra-low gilt yields demonstrate this point: again, most Mixed Investment 0-35% Shares (or what used to be Cautious Managed) funds have a high level of exposure to gilt yields. They work on the static assumption that gilts still equate to a safe haven, but who knows – can we say for sure that they will be low risk in the future? This exemplifies the need for a forward-looking model, which has the flexibility to negotiate the ground between long- term, strategic considerations, and short-term market aberrations.
Classifications are not helping
So back to the underlying aim of the client. Current sectors do not represent the risk that investors are taking for the outcome that might be achieved – evidence has shown a wide dispersion between the funds, in terms of volatility levels and performance. The different outcomes highlight a fundamental flaw in the risk-rated concept: the buyer is heavily reliant on a historic precept of risk, which does not, indeed cannot, anticipate risk that the fund manager might take in future.
At the very least, a significant level of due diligence is required. Fund buyers are reliant on style constancy, past performance, and current sector guidelines. The fatal error with the sectors is the comparison of apples with pears, coupled with a pressure to achieve performance quartile ranking.
We believe this inherent competitiveness only serves to encourage excessive risk-taking, and not always an outcome that the sector names would infer. Thus, if a manager is allowed to have 35% of their portfolio in equities to qualify as a cautious fund, they will tend to maximise this exposure to generate the highest returns, and therefore the best quartile rankings. Also, this approach is utterly ignorant of the changing behaviour of an asset class in relation to the market of the day and of course the correlation between asset classes, and the changes in correlation that occur.
Meanwhile, while it is questionable whether the underlying investor actually cares if the fund is the best, we’d wager they do care if the fund has not met its investment objectives. The beauty of risk-targeted funds is that they remove the conversation about quartile-ranking, instead allowing intermediaries to concentrate on matching the clients’ aspirations with what they wish to achieve through relationship management, and away from unsuitably competitive behaviour.
So to be meaningful in the selection process, comparison of multi-asset funds must be based on the risk they are taking relative to equities, rather than by their equity exposure per se. This will allow a simple understanding of the sort of ride an investor can expect, whilst freeing up the manager to invest the money in a way they believe will achieve a good outcome within the risk tolerance. Secondly, each sector should have an ideal time horizon to which an investor should be willing to commit money especially if there is an extreme market event. There should be a clear description at the sector level about the nature of the funds contained within them, and how each sector relates to the others, so that the hierarchy of risk between sectors is clear.
Lastly, any funds not being run in this manner should be placed in a specialist sector where sector comparisons should be banned, as is currently the case for the unclassified sector.
Without the appropriate forward-looking processes and risk measures in place and a time frame by which to measure them, fund managers cannot be sure what risks they are taking. It follows that the adviser then cannot be sure whether the product he has chosen will continue to match the client’s risk tolerance and circumstances nor can he make realistic comparisons between competing products if the basis for comparison is fundamentally flawed.
Further information on the Rathbone Multi Asset Portfolio, go to: www.rutm.com