Risk targeted funds - too new to perform?

Frank Potaczek, Head of Insight and Consulting (Investments)

It's probably fair to ask whether it's still too early to judge if risk targeted funds will stay within the volatility ranges that the majority of them are managed to, given that they have only been around for a short time.

There were few risk targeted funds during the testing market conditions of the second half of 2008. Can we look at any other fund styles to give us a proxy idea of how risk targeted funds might perform? Well, in 2008, for example, the then relatively new absolute return funds were really put to the test for the first time. Most of them fell a long way short of respective return targets. But we need to keep in mind it is generally easier to meet a volatility target than a return target. That is because adding or reducing cash within the portfolio allocation can give a lot more predictability to realised volatility.

The measurement period also plays an important role. Investors, advisers and rating agencies generally look for consistently positive annual returns from absolute return funds; volatility is more typically measured over three or five years annualised. And the longer the period of measurement, the more stable it tends to be. However, risk targeting could be an issue for performance because of the trade-off between risk and return in investment.

Track record

Risk targeted funds have taken off as a peer group in response to the implementation of the RDR and the introduction of formal measurements of client risk attitudes.

A lot of the funds were actually launched in the run-up to the RDR, some shortly afterwards - and a minority pre-date RDR by several years. So, many have existed for a meaningful time period, although not quite a full market cycle. Moreover, many of them are run by managers or teams who have track records on similar funds. 

Specifics of risk targeted funds

Most risk targeted funds look no different from traditional multi-asset funds within the Investment Management Association’s (IMA's) Mixed Investments peer groups. However, they are managed to a risk target (typically stated as a volatility range) rather than being constrained by the asset allocation ranges of the relevant IMA sub-group. That means, we look specifically at the interaction between asset classes or correlation of assets.

The typical approach taken by a risk targeted fund is to have a strategic asset allocation (SAA) that is aimed at maximising the long-term returns for the given volatility range, taking into account the historic behaviour of individual assets within the fund’s investment universe. The manager may then seek to improve returns through funds or securities selection as well as tactical asset allocation (TAA) around the SAA.

It needs to be noted though that the TAA should also adjust to meet the risk target. That means, in periods such as the second half of 2008, second quarter of 2010 and third quarter of 2011, when market conditions were volatile, you would expect fund managers to adjust funds' asset allocations to reduce exposure to risk assets such as equities and low grade credit, and add to cash and quality bonds to ensure that funds keep within their volatility bands.

Performance within the risk bracket

When applying this kind of course correction, that leads to the manager selling (equities and low grade credit) at low prices and buying (quality bonds) at high prices, it could detract from performance unless market movements are closely aligned with previously calculated expected returns.

The constraints on traditional multi-asset funds do not force them to buy high and sell low. If a fund in the Mixed Investments 20-60 sub-group has equities exposure of 59% going into a period of rising volatility and falling markets, its manager does not have to sell equities and/or other risk assets. They may even be able to add to holdings of equities because de-risking of them will tend to push their percentage allocation further below the 60% ceiling.

Taking a longer-term view

As risk targeted funds become more mainstream, there should be more standardisation of the measurement period for volatility. One argument may be that it will serve investors better to have a longer measurement period, for example five years, since this would be less of a constraint on delivering performance that is competitive with traditional multi-asset funds. Besides, it's statistically more significant.

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