By Robert Stock The FSA proposal to risk grade fund sectors may help consumers understand more about...
By Robert Stock
The FSA proposal to risk grade fund sectors may help consumers understand more about their finances but depending on the definition of risk used, it could create further confusion.
The Oxford English Dictionary defines risk as "the chance of loss or bad consequence". From a personal finance perspective this raises two basic definitions.
The first is the risk of losing money, and here an equity investment has a greater chance of this than a building society. Secondly, there is the risk of not generating enough money in the long term by avoiding market exposure.
According to Autif, the risk of loss over one year of the FTSE All-Share Index, which grew by an average of 16.26% annually between 31 December 1985 and 31 December 1998, is 21%.
Over five years that falls to 3%. Over 10 years 100% of investments have grown. It is a point backed up by the Barclays Equity Gilt Study 2000 which shows over the last 100 years equities have outperformed the supposedly less-risky cash 92% of the time over any 10 year period.
The length of time an investment is held for has a marked effect on risk/return dynamics.
Bambos Hambie, director of global equities at Friends Ivory & Sime, who selects funds for the group's multi-manager fund of funds, agreed opportunity costs are an important factor clients needed to take into account.
He said: "Studies have shown this is potentially a very high risk area for investors. The opportunity costs of what can appear to be a risk free investment, such as a building society account, can be massive. Investors who have kept cash on deposit during the last 10 years will have missed out the tremendous returns from equities over that period." However, this is not the type of risk assessment the FSA is likely to introduce when adding risk ratings to its comparative league tables.
It intends to include comparative risk assessments of different asset classes and possibly equity sectors.
The proposed decision trees for stakeholder pensions created by the FSA also tackles risk, but for the moment only as a warning that investors may buy into an unsuitable product for their needs, or one which they will not be able to contribute enough to in order to generate the level of income required in the future. Among life companies, the debate on this continues, especially as the presence of a default fund under stakeholder and the low cost of the product have many wondering about a suitable generic product for investors of varying ages. There has been suggestions that trackers will be appropriate, however, many have deemed them to be too risky for pension investors. Trackers are seen as offering little downside protection as they simply follow the index.
The FSA says it will not include risk comparisons between individual funds as it has decided not to include past performance in this table. However, Autif believes risk by its very nature must be calculated on historical performance as it is only in retrospect that one sees the volatility of the sector or fund in which they are invested in.
Autif and the ABI have both been in discussions with the regulators in order to come up with some agreement on how to rate risk. Little has been decided, although the FSA remains convinced that if risk is to be included it must be at the sector level, whereas Autif believes this to be inappropriate.
Anne McMeehan, director of communications at Autif, said: "If you look at something like technology stocks there is a very big difference between a fund that invests in large-cap stocks, like BT, to being invested in dot.com specials which have been recently launched, have no track record, assets or profits. You are looking at two different types of fund in one sector."
As many as 10% of funds in the Autif sector could be considered as not meeting the general risk profile of their peers, she said.
Fund risk levels also change with fund manager departures, new holdings taken, benchmarks changed, none of which are immediately visible.
As well as the fund-implicit factors, such as management style and star-based versus team-based management, there is also market risk, which is the likelihood the value of an individual investment vehicle will move in tandem with the market as has happened with technology funds. Other factors Autif believes investors need to be aware of include interest rate risk, inflation risk and credit risk, all of which depend on where the investors are placing their money.
With this many factors to consider, and this many interpretations of risk, Autif believes the most effective way of assessment is to look at time frames.
McMeehan said a product providing acceptable risk returns for 20 year olds is unlikely to have the same risk profile for someone nearing retirement.
She said: "People tend to forget the perspective of time is not included in the risk assessments. An emerging markets fund within a wider portfolio can, over time, reduce the overall risk/return. In the short-term it can look like a very high risk investment."
Hambie said: "I think many investors are very underinformed about risk. Part of the problem is each individual has their own idea of risk, but does not know how to define it in terms of investing. It has been highlighted by sales of high yielding corporate bond funds. The sales guys for those funds talk a very good story, but do the individual clients really understand the risks behind the attractive numbers?"
For Jason Hollands, deputy managing director of Best Investments, it is not a matter of assessing risk but minimising it for clients.
He said: "A lot of people have suffered losses of up to a third of their assets going into technology funds.
"If they had spread their investments they would have bought some on the way up, some at the top and some on the way down and would have fared much better than they
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