Financial advisers face tighter scrutiny than ever before in justifying the investment decisions they make for their clients.
So one route that many are taking to try and ensure the investments they use are suitable for a given client's risk profile is to recommend 'one-stop-shop' multi-asset funds that are specifically designed to manage risk - which generally involves controlling the volatility of the fund's portfolio.
There are two ways this may be achieved: through 'risk rating' (where funds are given a rating of, say, between 1 and 7 according to their 'riskiness') and 'risk targeting'.
How do the two types differ? Risk-rated funds tend to be in the Investment Association's mixed-asset sectors, meaning equities make up only a stipulated percentage of the underlying investments.
So to remain in, say, the medium-risk mixed-asset band, a fund has to hold between 20 and 60 per cent equities. Because equities tend to be more volatile than other asset classes, riskiness is effectively defined in terms of the percentage of equities held by a fund.
However, fund managers are ultimately competing for the best return and highest ranking within their sector, rather than trying to stay at a certain risk level, so (all else being equal) they will tend to edge towards the higher (60 per cent) end of the equity range to boost returns.
The key thing here is that a risk rating is assigned (by third-party companies) at a single point in time, based on the proportion of equities currently in the fund. But a financial adviser using that rating couldn't be sure that the fund manager hadn't meanwhile skewed the proportion of equities in it.
The worry is that if advisers rely too heavily on risk ratings to save time finding suitable funds for clients, and don't look under the bonnet at current fund composition, they may not actually be seeing the whole picture as far as risk is concerned.
Risk-targeted funds, in contrast, are forward-looking. A risk-targeted fund seeks to maximise returns to investors while remaining within a given risk profile - that is to say, a certain level of volatility. So if a risk-targeted fund is labelled 'balanced', its manager will try to keep its volatility at levels suitable for 'balanced' investors.
So risk-rated funds have been assigned their ratings based on risk level at a single past point in time, whereas risk-targeted funds actively aim for a certain level of risk.
Risk-rated funds don't do this - within broad sector parameters, nobody is trying to keep a risk-rated fund at a consistent level of risk (in terms of the level of equities, or indeed the type of bonds held) and its rating could therefore change over time.
Risk comes first
David Coombs, head of multi-asset investments at Rathbones, puts it more succinctly: 'A risk-rated fund sees return as its primary objective, with its risk level as a secondary consideration, whereas a risk-targeted fund aims for the maximum possible return within a given risk parameter.' Risk comes first and return follows, in other words.
The popularity of these risk-linked vehicles is increasing. Research by Rathbones found that almost two-thirds of financial advisers expect to see an increase in their use in the next three years. More than four out of five advisers said they would offer risk-rated or risk-targeted investment solutions for clients with pots of between £51,000 and £100,000.
Anecdotally, Coombs says advisers are enquiring more frequently about risk-targeted funds than previously. 'Lots of firms we are talking to have been using "attitude to risk" questionnaires and new modelling systems to help define a client's risk profile. Therefore a lot of the discussion about suitability is about risk.'
However, he adds that looking only at an investor's attitude to risk provides an incomplete picture. Advisers should also look at their clients' capacity for loss. For example, someone might be too cautious to take the risk necessary to generate returns that meet their long-term investment goals.
There are other potential pitfalls as well. In risk-targeted funds a manager might tend to be too cautious, says Coombs. 'At the end of the day, if you put your portfolio in cash you will hit your risk target, but you might not meet your return objective. Don't forget the return element as well.'
Because risk-targeted funds can be for any risk level, there is no particular investor-type that is best suited to them. But these funds are particularly relevant once people are drawing an income from their portfolio and trying to make it last a certain length of time, rather than building up capital.
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