How to talk risk with your client

Patrick Norwood – Insight Analyst (Funds)

Institutional investors will often use an array of sophisticated portfolio risk measurements, covering dispersion, systematic risk, downside risk, drawdown and tail risk. Retail investors and private clients are, of course, different from institutional investors in several ways.

Retail and private versus institutional investors

One of the main differences between them is how each measures performance and success. Institutional asset managers are usually measured relative to a benchmark. For example, if the FTSE 100 declines by 10% but the UK large cap fund falls by ‘only’ 5% over the same period then it will have been successful!

Institutional investors will therefore use benchmark or index-related metrics such as tracking error and beta to judge managers. Retail investors and private clients, however, think on an ‘absolute’ basis, being more concerned with preservation of wealth and risk of loss.

This key difference raises a couple of questions:

• Which risk metrics are best suited for use with private clients?
• Given retail investors’ relative lack of knowledge in risk and portfolio analytics, how can firms and advisers communicate risk effectively?

Importance of downside risk

As private investors have a more absolute mindset, downside risk should play a big part in discussions with clients, and metrics such as semivariance (where only deviations of returns below the mean or target are considered) and maximum drawdown (maximum peak-to-trough decline of an investment over the relevant period) exist for the more sophisticated clients.

Another way to look at downside risk is to project forward the client’s investments using suitable return, risk, correlation and future payments assumptions, giving a probability distribution of the value of these investments at some point in the future. The adviser is then able to show the client what the chance is that their investments will be at or above their target value at that point in the future.

The adviser can then look to manage that risk better and make sure the client is not exposed to more risk than is necessary in order to meet their goals. Conversely, the riskiness of the client’s portfolio can be increased if it looks like they only have a small chance of reaching their target.

Effective communication

The quantitative background of professional investors is clearly much higher than that of the general public, therefore explaining investment risk to the latter requires a different approach. This has been made easier, ironically, by the 2007/8 credit crisis and subsequent effect on equities (the FTSE 100, for example, lost around 30% in value in just over a month from early September to mid-October 2008) and most other asset classes around the world. Almost everybody remembers 2008, therefore it should be easier now for advisers to explain and talk about downside risk, drawdown and even tail risk to clients using this very real example rather than abstract theory!

Fund factsheets usually include various risk indicators as well, such as country and industry over/underweights plus market cap distribution in the case of equity funds. These sheets have gradually become a bit more sophisticated over the past few years, with some now including measures such as Value at Risk (VAR). In parallel with this, the more progressive advisory firms are adopting additional risk metrics and these trends should continue going forward.