Why different risk rated funds should not be combined to meet one objective

Nancy Mills, Insight Support Analyst (Funds and DFM)

Defaqto’s ten numbered risk profiles, which inform the Defaqto Risk Ratings, are defined by risk (or volatility) over a 10 year period. Each fund risk rated by Defaqto is allocated a Risk Rating having had their expected and realised volatilities carefully considered together with a face to face conversation with the fund manager. Defaqto’s risk rated funds are designed to offer a client a multi-asset solution that is in line with the risk profile that has been agreed with their adviser. They are a ‘one stop shop’ and, ideally, should be used singularly to meet an objective.

It might seem logical to recommend a portfolio of risk rated funds; combining a fund that is risk rated 4 with one that is risk rated 6, to achieve an overall risk level of 5. On day one, the combination of the two funds could very well achieve the outcome you are aiming for – it’s later down the line where the problems may occur.  

To explain this further, we need to consider Harry Markowitz’s Modern Portfolio Theory (MPT).

Modern Portfolio Theory suggests that it is possible to construct optimal portfolios that offer the maximum possible expected return for a given level of risk. These portfolios are said to lie on the ‘efficient frontier’.

The idea is to diversify across different securities, sectors, markets and assets in order to reduce the overall level of risk within a portfolio. Generally, the lower the correlation between asset classes, and the greater the number of asset classes we diversify across, the more we can reduce the level of risk in the portfolio.

Asset allocation is, therefore, the major determinant of risk and return for a given portfolio. For each risk rated fund, Defaqto use the asset allocation of the fund (both tactical and strategic, where available) and run it through Moody’s Wealth Scenario Generator Model. This model is driven by historic market behaviour, current market valuations and structure, as well as forecasts of future market behaviour, returns and correlations. It is stochastic and considers a range of scenarios and outcomes for asset classes. Using Monte Carlo simulations, the model can calculate expected and percentile returns for each asset class. This will produce a future volatility figure; this is the expected annualised 10 year volatility of the fund.

Over time, assets in a portfolio will produce different returns. Within a single multi-asset fund, the professional investment manager will perform any rebalancing that may be required.

If you were to combine two funds with different Risk Ratings to achieve, in theory, a combined risk level, in order to maintain its original risk and return objective, it will be your responsibility to rebalance the client’s portfolio. Failure to do so will expose your client to more or less risk than they need and, indeed, agreed to. With this rebalancing comes many other considerations which I will outline below:

• Costs
  • Tax liabilities – capital gains tax may be due upon the sale if the asset sold has appreciated in value
  • Transaction costs – there may be a bid/offer spread or redemption or purchase fees
  • Time and associated costs – cost incurred either by the investor and/or the adviser for the administrative costs involved
• Extra administrative work
  • Getting your client to sign to authorise the transaction
  • The time involved in completing the paperwork
  • Ensuring that rebalancing is done with sufficient frequency; not too often and not little
  • Time needed to record the recommendation to rebalance
• Trading restrictions – there may be trading restrictions on a particular fund meaning that rebalancing isn’t possible at the chosen time
• Potential compliance issues

The funds that Defaqto risk rate are multi-asset and any rebalancing is done within the fund by the investment manager. You can be confident that, aside from any changes to your client’s required risk level, that the Defaqto risk rated multi-asset fund that you have recommended, remains suitable. There is no real need to further diversify your client’s portfolio from an asset class point of view. If you have a particular need to diversify further (ie your client doesn’t want all their money in one fund), you could choose to recommend multiple funds that all have the same Defaqto Risk Rating.