Andrew Morris: How important are risk ratings?
With adviser time in such scarce supply, Andrew Morris explains how an efficient way to deliver a suitable client outcome can be by way of a focus on 'risk-rated' products ahead of 'risk-profiled' ones
In To diversify … or not?, we considered the importance of diversification in investigating what place multi-asset funds inhabit in today's low-cost, tracker-dominated world. It is imperative suitable multi-asset products are available for clients in order to ensure their risk requirements and appetite are fully taken into consideration.
The universe of funds available is, however, huge and encompasses an array of fund options and strategies. One way in which advisers are able to filter this universe is through risk-ratings - although this is not as simple as it sounds. This is because funds can either be ‘risk-targeted' or ‘risk-profiled'. Although these may sound similar, there is an important differentiation.
With companies such as Dynamic Planner to the fore, risk ratings assign a numbered risk level to products. Typically numbering between 1 (lowest risk) and 10 (highest), these numbers indicate how risky a fund is deemed to be. They do not always specify, however, whether they are risk-profiled or risk-targeted.
Importantly, risk-targeted funds are managed according to strict asset allocation guidelines and/or volatility boundaries to ensure the product's level of risk always remains at the same level. In contrast, risk-profiled funds are allocated a risk level largely based on their current asset allocation and past behaviour. As such, a current risk profile 3 could become a more risky 4 in the future, or vice versa.
So what do all these ratings actually mean? Dynamic Planner risk-profiled products have the flexibility to invest where they wish, meaning they are able to change risk levels. In the IA Mixed Investment 0-35% sector, for example, there are 15 risk profile 3 funds and 14 risk profile 4 funds.
Over the last three years, if looking at only risk profile 3 funds, the best performer has returned 23.87%, whilst the worst performer has returned just 1.32%. The range of performance outcomes across the other sectors are similarly wide.
In contrast, risk-targeted funds are managed to strict asset allocation limits, set by Dynamic Planner. All funds must adhere to these and so their risk rating remains constant. They are still actively managed, however, as the selection of assets within each predefined limit is obviously left up to each individual manager.
Interestingly, there is a tighter grouping of performance and risk outcomes in this space, with allocation perhaps having a greater impact than selection on the overall fund profile. Of all the funds available with a risk-targeted Dynamic Planner 3 rating, for example, the worst performer over the last three years returned 13.54% and the best 20.70%. For Dynamic Planner 6 risk-targeted funds, the performance range is eight percentage points over the last three years. By way of comparison, for Dynamic Planner 6 funds in the risk-profiled space, the range is nearly 50%.
Perhaps most interestingly, the average three-year performance of the IA Mixed Investment 0-35% sector is 15.13%, while the performance of the average risk-target managed Dynamic Planner 3-rated product is ahead at 18.42%. But how does the performance of the Dynamic Planner average risk-profiled and risk-target managed fund compare? Below, we have highlighted two examples, showing the average performance of risk levels 3 and 6.
Risk-Target Managed Leading The Pack
As you can see, risk-targeted funds tend to outperform their risk-profiled counterparts. In addition, the range of performance outcomes is much more concentrated, suggesting they can better suit a specific client's risk and return requirements.The latest data shows risk-profiled funds tend to have a lower average volatility - however, the volatility range is a lot wider, with many risk-profiled funds exhibiting volatility that would fall outside of their given risk level.
Yet what does this mean in the grand scheme of things? As regulations have increased the workload on advisers, fund screening - using risk ratings or other means - or indeed the entire outsourcing of investment decision-making has increased significantly. As a result, so has the managed solution offering.
Here we have attempted somewhat to unpick the complex world of risk ratings. With adviser time in scarce supply, we believe the above highlights that an efficient way to deliver a suitable client outcome can be achieved via a focus on risk-rated products.