Chris Fleming explores how to best link a multi-asset fund into the advice process to match suitability, taking a deeper look at risk-mapped and risk-targeted solutions...
The terms risk-mapped and risk-targeted are often misunderstood and used interchangeably. This is incorrect and the two terms should not be confused.
The key difference between risk-mapping and risk-targeting is that the former is a process for aligning funds into a suitability framework based on a unique risk-scoring algorithm and the latter is an investment approach to managing fund solutions. A suitability framework in this context could represent a centralised investment proposition.
Risk-mapping is the process of linking or scoring any fund, or family of funds, into a suitability process. The fund being mapped may or may not have risk, or a risk-target, as a specific objective.
How the risk-mapping is determined is unique to each process but could simply be based upon the fund’s percentage equity holding, or through the adoption of capital market assumptions that attempt to display an expected level of portfolio volatility which is then usually aligned to a pre-determined volatility band
How the risk-mapping is determined is unique to each process but could simply be based upon the fund's percentage equity holding, or through the adoption of capital market assumptions that attempt to display an expected level of portfolio volatility, which is then usually aligned to a pre-determined volatility band. Both approaches therefore enable a fund to be risk scored and categorised based on the risk output.
Risk-mapping models that take the percentage equity approach can be criticised for being overly simplistic and ignore the interaction that other asset classes may have on a fund's overall risk score. Alternatively, models that take the capital market assumptions approach are heavily reliant on how the asset classes are defined and then how funds are aligned to those definitions.
They also assume that every fund within its asset class categorisation aligns neatly to the asset class definition and therefore has the same ‘risk' assumption. In reality, however, there can be a great level of dispersion between how funds behave within a categorisation. This becomes particularly challenging when trying to map funds that hold alternative asset classes or derivatives that can dramatically alter the expectations driven by the asset class assumptions.
Risk-targeted solutions are usually offered as a family of funds and focus on providing a range of volatility-based outcomes to cater for a range of risk appetites. They are often associated with one suitability process in mind but can be risk-mapped into other suitability frameworks.
When risk-targeted funds have been created to align with one suitability framework the fund's risk score will remain consistent and relevant to that framework. However, when they are risk-mapped to other frameworks, the risk scores will be more likely to move over time as either the asset allocation or the capital market assumptions change.
A typical suitability process begins by assessing a client's willingness to accept investment risk, via an attitude to risk questionnaire, and then further explores their ability to accept losses via capacity for loss analysis. The process should also consider the client's knowledge and experience plus any specific goals (often labelled as needs) and collectively looks to establish the client's risk profile. This is then often aligned to a range of appropriate investments but how this alignment is created, if that is indeed the intention, is arbitrary. It is simply down to what the provider of the suitability process has deemed to be an appropriate range of investment solutions based upon the consistent approach taken to risk categorisation.
Therefore, when selecting appropriate multi-asset investments, it does not necessarily matter what attitude to risk questionnaire is being adopted (other than personal preference and usability) as this is simply going to rank a client's willingness to accept risk based on a sample population. What is more important is that funds are risk categorised in a consistent manner to enable clear comparisons to be made with other funds in the market, and those adopted within the wider suitability process.
Additionally, when determining what makes an appropriate investment for a client it is important to realise that the risk-mapping processes defined here are predominately quantitative in nature and often rely heavily on expected volatility (as measured by standard deviation) for its ranking process. While standard deviations are a recognisable and understandable statistic for comparing and ranking funds, it is useful to compare other qualitative and quantitative aspects before making final fund recommendations.
Chris Fleming is investment services director at Square Mile Investment Consulting and Research
This article was first published in the February issue of Professional Adviser's sister title Multi-Asset Review. To make sure you receive your own copy of the next issue, please do register your interest here
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