Graham Bentley discusses the growing popularity of risk-rated funds
Even at the mundane level, risk governs every decision we make in our lives, from alarming the house, to parking on double yellow lines. Assessing risk before making a decision is natural human behaviour and when it comes to investment the same principle applies: understanding a client’s attitude to risk through a risk profiling process before building an investment portfolio is of paramount importance.
When making investment decisions it’s important to understand that for most people the pain of loss is felt more than twice as intensely as the pleasure of an equivalent gain. Investors over the year to 14th April 2010 have experienced returns on equities of up to 95%*. On the other hand, recent market turbulence has seen falls approaching 10% and, as a result, many advisers are refocusing on controlling risk as opposed to chasing maximum returns. Recent research** confirms this, with 80% of all advisers surveyed believing that controlling risk is more important than maximising returns.
As both advisers and investors become more switched on about risk and the effect it can have on portfolios, we see an increasing number of advisers embedding a risk profiling process into their business proposition.
Once a portfolio has been constructed around the client’s risk profile, it should be regularly monitored to ensure the volatility of the assets remain in line with client’s risk appetite. Should the volatility of the portfolio drift from the client’s risk profile then the portfolio should be rebalanced to ensure the correct level of volatility is maintained, thus ensuring the portfolio performs in line with client expectations. This can be a time consuming process for the adviser, especially when dealing with a large number of clients who are likely to have differing appetites for risk. One effective way to manage this process is to use risk-rated, i.e. volatility targeted, funds.
Risk-rated funds are designed to operate within a specified range of volatility, and are regularly reviewed and rebalanced by the fund manager to make sure they stay in line with the clients’ expectations, e.g. downside risk. This can reduce the time advisers spend reviewing portfolios. Importantly, risk-rated funds also remove concerns about CGT liabilities being crystallised on portfolio rebalancing, as their structure ensures CGT only applies on redemption of the fund’s units, and not on trading inside the fund.
As more people begin to appreciate the importance of investing in line with risk appetite, the popularity of risk-rated funds is increasing. Research shows that 39% of advisers* predict that the use of risk-rated funds is set to increase through 2010. According to advisers interviewed, the growing popularity of risk-rated funds can be attributed to two key things: 35% of advisers see the key benefit of recommending risk-rated funds being that the volatility of the fund is more closely aligned to the client’s risk appetite. The fact that risk-rated funds help advisers explain investment risk more easily to clients was the most important benefit for another 22% of advisers.
The popularity of risk-rated funds is increasing at such a rate that many advisers believe risk-rated funds will replace the traditional active, balanced and cautious (ABC) funds. Of the 63%*** of the advisers who currently recommend ABC funds to clients, 68% believe risk rated risk-rated funds with set volatility targets will eventually replace ABC funds. This can be attributed to risk rated funds aiming to deliver investment returns commensurate with their respective controlled volatility ranges and, as each fund is matched to a specific level of volatility, investors can get a better understanding of their likely returns. In contrast, funds in each active, balanced and cautious category can exhibit a wide range of risk and return because the constraints are simply on equity exposure, not volatility. All asset classes can exhibit higher volatility but this is not accounted for in the ABI and IMA sector qualifications.
Modern risk assessment analysis techniques allow advisers to better assess their clients’ attitudes to risk and risk-rated funds provide an investment choice that can often suit clients’ needs more accurately than traditional ABC funds. By delivering to clients’ needs more accurately, the advice process can help boost investor confidence and empower investors to plan for their future with more certainty and this, after all, is the ultimate aim of financial advice.
Graham Bentley is head of investment marketing at Skandia
*Financial Express: SVM UK Opportunities bid to bid net income reinvested
**Survey of 1428 financial advisers by Skandia
***Further survey of over 1300 advisers by Skandia
Moves to overweight equities and fixed income
The Big Interview: Focus on ethical investment
View from the front row
'No control or oversight'
359 new customers in 2018