How to choose a risk targeted fund

Patrick Norwood, Insight Analyst (Funds)

Risk targeted funds exist as ‘families’ of funds offered by a firm, with each fund in the family targeting a different level or range of risk. This will be achieved mainly through different asset allocations across the family. Each fund in the family can therefore be used by different investors, depending on their risk tolerance.

The choice of risk targeted fund depends on many things. Firstly, does the investor believe in active or passive fund management? With active management, there is the chance to outperform the respective index, but also the risk of underperforming it. Passive funds, meanwhile, simply track the index and will normally be much less expensive. Some risk targeted portfolios hold only active funds, some have just passive underlying funds while others contain a mix of the two. In most cases, though, allocation between the different underlying funds will be active.

Secondly, there is the option of (mainly) fettered or unfettered risk targeted fund families.  With fettered, the underlying funds can only be chosen from elsewhere within the fund management organisation while in the case of unfettered they can be chosen from any fund management firm. The big advantage with the latter is that the opportunity set is much larger, not only in terms of funds but also investment styles and strategies, with the result that the risk targeted manager should be able to achieve greater diversification. With fettered funds, however, costs will usually be lower and the risk targeted manager will have constant and more detailed access to the underlying fund managers - often they will be sitting just a few desks away from each other! Also, fewer managers to concentrate on allows for greater focus.

The other big decision regarding risk targeted funds is whether to select one which invests in just ‘traditional’ asset classes - equities, bonds, cash and maybe property - or one that invests in traditional and ‘alternative’ assets, such as private equity, commodities and infrastructure. The latter type offer greater potential for higher returns and diversification; however, they can also be more risky and expensive and less transparent.

Once the above choices have been decided upon, then many of the general fund selection factors will apply in deciding which risk targeted fund family to select: strength of underlying business, quality of the fund managers, investment process, costs and performance, preferably risk adjusted. Additional criteria, specific to risk targeted funds, which should also be considered include number of funds in the family. More funds in the family is better, as it means that advisers can more closely align a fund’s objectives to the needs of a particular client.

At Defaqto, we also look at family ‘risk shape’ as part of our Diamond Rating for risk targeted funds, which consists of three different proprietary measures:

• Spread - the range of risk available in the family of funds, calculated as the difference in risk between the maximum and minimum risk fund, with a wider spread being seen as better.
• Consistency - how even the increases in risks are when moving from each fund within the family to the next most risky one and calculated as the variance of these changes in risk, with a lower variance (i.e. more even steps in risk) being seen as better.
• Shape - according to investment theory, if investors take extra risk they should be rewarded with higher returns, at least over the medium to long term.Shape measures the conformity of the family of funds to this expected positive relationship between risk and return, with a closer fit to this pattern getting a higher score.