Taking risk shape into account

6 January 2015

Patrick Norwood - Insight Analyst for Funds

When assessing risk targeted funds, the most important thing Defaqto considers is the ‘risk shape’ of the fund family. In fact, risk shape currently forms nearly 40% of our Diamond Rating for these funds.

Risk measures

The measure of risk we use is volatility (standard deviation), although we acknowledge that volatility is not the only measure of risk and people will use other measures such as maximum drawdown and liquidity.

When considering a fund family’s risk shape we use three different metrics, with each having equal importance:

Spread

We define the spread as the measure of the breadth of risks available in the family of funds and calculate it as the difference between the maximum and minimum standard deviation, with a wider spread getting a higher score.

Consistency

Consistency is our measure for how evenly spread the risks are in the family of funds and we calculate it as the variance of the changes in risk when moving from each fund within the family to the next most risky one, with a lower variance (more even steps in risk) getting a higher score.

Shape

According to investment theory, if investors take extra risk they should be compensated by higher returns. Our shape score measures the conformity of the family of funds to this expected positive correlation between risk and return, with a closer fit to this pattern getting a higher score.

Diamond Ratings

Up until recently it was a challenge for many advisers and clients to compare risk targeted funds in a meaningful way. We feel that our Diamond Ratings for these funds are unique in that they consider the funds as a family rather than individually and look at their risk shape rather than just performance.

Fund families scoring well on the three risk shape measures listed above will generally offer investors steady increases in potential return for a given amount of potential risk, right across the risk-return spectrum.

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