What’s the risk with risk-rated funds?

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In the aftermath of the 2007 financial crisis, investors have understandably become more risk averse. There has been a shift away from riskier investment vehicles and a rise in popularity of risk-rated funds, which are managed so they aim to stick within certain risk boundaries rather than meet a return objective. 

But are these funds the best way to manage risk? Some industry experts fear advisers still do not do enough due diligence to ensure their own assessment of clients’ risk appetites matches the rating of a fund. 

In February, FCA technical specialist Rory Percival warned advisers using discretionary fund managers run the risk of “systemic misselling” if their clients’ risk profiles are not correctly mapped against those of the outsourced investment solution.

He said the regulator has seen evidence that some advisers are not ensuring the risk profiles they use are aligned to those used by the DFM. 

“Risk profiling is the key problem. If an adviser firm is carrying out risk profiling and the DFM is running portfolios that will always have risks associated with them, who is making sure one matches up with the other? Mapping is key,” Percival said.

“A DFM’s portfolio risk may be different from the advisory firm’s assessment of risk. They need to be matched, otherwise you have effectively got systemic misselling on your hands.”

Equilibrium Asset Management investment manager Mike Deverell says risk profiling came about as a response to regulatory pressure. 

He says: “Sometimes people develop products more with compliance in mind than the clients. Risk-rated funds are a good idea but you have to be careful how you use them. It seems an easy option from a box-ticking point of view but that does not mean it is appropriate. Obviously, good advisers will realise this.”

Capital Asset Management chief executive Alan Smith warns advisers should be careful not to take risk-rated funds at face value.

He says: “In a post-RDR world there is a ‘set and forget’ mentality and advisers think they do not need to do much. Advisers need to be extremely careful and selective and look at what is actually owned by the funds.”

While risk profiling is seen by some as a move to simplify the risk universe and make it easier to choose between different products, Smith is sceptical that risk profiling achieves this.

He says: “There is a difference between risk tolerance and risk capacity, and I am not sure the industry understands this or how to explain it to clients. Our view is that, historically, risk-rated funds can be dangerous as they are given vague titles. The whole issue of risk is very complex so to put it in a box with a label can be difficult.”

Lift Financial group technical director Joel Adams has been working with a range of risk-rated portfolios since the late-1990s and is mindful of the potential danger that confusion between risk tolerance and risk capacity can play.

He says: “You should not just analyse someone based on tolerance. Static and arbitary scoring does not work so you need to take into account a client’s holistic circumstances. For instance, they might be able to afford a lot of risk but may not need to take any.”

Chelsea Financial Services managing director Darius McDermott believes that risk profiling can be effective as long as clients’ risk profiles are continuously reviewed.

“There is a danger advisers could become reliant on profiles but I do not think it is likely. The key thing is that a risk profile changes with an individual over time,” he says. 

“For example, you want more risk when you are 30 than when you are 60. It is down to the adviser to make sure the risk profile changes with the client.”

Henderson head of multi-manager sales Jon Hodesdon, who works on a range of risk-profiled funds, says the rise of risk profiling has come in response to evolving attitudes towards risk.

He says: “There has been a failure of some funds to meet people’s expectations and investors now want a more structured approach. It gives more comfort to investors that we aim to stay within certain parameters. If we meet our client’s expectations all these products work effectively.”

Investec Asset Management UK client group managing director David Aird warns sticking to risk parameters could bring a restrictive rigidity to investing: “To run a portfolio against one metric is fundamentally wrong. The outcome for the client’s return could be horrendous.

“You cannot create a consistent outcome for clients if you run a fund to a hard-coded risk target. The Financial Conduct Authority should be concerned that in three to four years’ time these risk-rating clients will be unhappy, though it could take years to manifest itself.”

The growing popularity of risk-rated funds has also attracted interest from the Investment Management Association.

The IMA is reportedly in the early stages of discussions with asset managers over the ratings. An IMA spokeswoman says risk-rated funds are not under any official investigation or review but she adds: “It is something we are exploring.”