To risk rate or not to risk rate?

Adrian Gaspar, senior consultant at Defaqto, on how to run due diligence across risk rated and multi-manager funds.

A topical theme in the IFA market currently is the challenge of matching ‘managed investment solutions’ to a client’s risk profile.

There are several ways of offering managed solutions including discretionary fund management services and model portfolios.

We are focusing here on risk rated funds (many of which are multi-manager and designed to map to output from risk tolerance questionnaires) and multi-manager funds (that are not risk rated) in two key areas: comparing what benefits each approach potentially offers advisers and clients, and the key areas of due diligence for each to ensure appropriate selection.

The aim of this article is to point out areas advisers may wish to consider when deciding which solution is most appropriate for their client, although my comments relate primarily to actively managed funds.

The options

Risk rated funds and non-risk rated multi-manager funds often take subtly different paths to achieving their goals.

Broadly speaking, risk rated funds are designed to outperform benchmarks, often composite, but within a defined risk budget as measured by standard deviation (volatility), while multi-manager funds usually aim to outperform a sector or benchmark, and are less restricted by their use of risk.

The self-imposed restrictions on ‘risk rated’ funds can help protect relative downside loss. Many multi-managers will also use their skills to manage risk where their mandate allows them the flexibility to move in to more defensive asset classes or use derivatives to ‘hedge’ positions. The main difference is that with risk rated funds there is more certainty of approach.

It is relatively easy to do a high level assessment of a multi-manager’s performance against a sector average (against which many are benchmarked). Many risk rated solutions are in the ‘Unclassified’ sector, with a composite benchmark, so this is slightly more difficult.

Where providers assign a risk rating to a fund, it should be remembered that this is not against any industry standard but usually against other funds within the company’s own range. A multi-manager fund may have different risk ratings depending on which distribution outlet is being used.

The key difference is that the relative risk profile of a risk rated fund should not change but that of a multi-manager fund can, and often does, change, as a result of the fund managers’ current tactical view.