Fund managers are facing pressure to buy high risk assets in order to meet their funds' targets in an environment of falling equity volatility.
Managers of funds such as the multi-asset range at Aviva Investors and the Harwood Multi Manager range, which have volatility targets, said even a 100% allocation to equities is not enough to reach the targets on the riskier portfolios.
Equity volatility is measured by looking at the standard deviation of returns from the mean. As equity markets have experienced a relatively steady rally since the start of the year, this deviation has been slight, which means volatility is low.
For example, the rolling 12-month volatility of the FTSE All Share has dropped from highs above 16% in July 2012 to lows of 6% in May this year, before reverting to around 9%.
The drop in equity volatility has made it difficult for higher risk funds to reach their target volatility levels, and has forced some to turn to riskier investment ideas.
Richard Philbin, CIO at Harwood Multi Manager, said: “The portfolio with the highest target volatility in my range has 100% in equities, and it is still only at the lower end of the volatility band.”
Risk of losses in market correction
As a result, managers are being forced to look up the risk spectrum for more unusual assets. However, Peter Fitzpatrick, head of multi-asset retail funds at Aviva Investors, has warned this approach may lead to significant losses in a market correction.
Fitzpatrick has significantly increased the allocation to equities in the multi-asset fund range since the start of the year, with the most aggressive portfolio currently holding 85% in shares.
However, he is avoiding riskier investments, such as emerging market equities.
“Investors should not assume this drop in volatility is permanent,” he said. “There will be a correction and they could lose a lot of money if they have taken on excessive risks.”
Chris Wyllie, CIO at Iveagh, who runs the Guinness family private accounts and risk-targeted funds, said investors increasing risk exposure may suffer the kinds of losses hedge funds experienced in 2006-2007.
“You should lean into the wind and reduce risk rather than increase it, because at some point the market will revert to the mean and the outcome will be a higher volatility than your objective,” Wyllie said.
“This outcome can be very extreme, and we have already seen a mini rehearsal of this in June. Do I feel comfortable increasing risk in this environment? Definitely not.”
To reflect this view, Wyllie has been trimming exposure to stocks within Iveagh’s portfolios.
“We take a long-term view in our portfolios, so we are happy to see our achieved volatility below the set range. Some funds target a consistent level of volatility, but this strategy is risky because volatility is itself volatile,” he said.
“Our funds have lower risk bands than our competitors, but because volatility has been so low over the past year, ours does not look much lower. But you only find out the difference when volatility goes up.”
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