Multi-asset funds: risk and suitability

Elements of this article first appeared in FT Adviser on June 18^th 2017

Patrick Norwood - Insight Analyst (Funds and DFM)

Multi-asset funds, as their name suggests, contain investments across several different asset classes - equities, bonds, cash, real estate and possibly other ‘alternative’ asset classes - with the fund manager deciding on the proportion going into each. At the one end of the spectrum, those funds investing mainly in equities, in particular with a significant Emerging Market component, would be expected to deliver higher returns over the medium to long term but also come with greater volatility; while at the other end of the spectrum multi-asset funds containing mostly bonds and cash should be less risky but will probably give less return in the long run. The latter would likely be more suitable for investors in or close to retirement and/or those uncomfortable taking risk while the former will probably be used by clients with a long time to retirement and able to tolerate higher volatility in order to achieve greater returns.

Some managers of multi-asset funds will invest in other funds specialising in the relevant asset class - known as multi-manager - while others invest directly in securities themselves. Also, the investment method may be active, passive or a combination of the two.

In addition, some multi-asset funds will directly target the risk (volatility) of the fund, usually aiming to keep it within pre-defined bands, with return being the secondary consideration. Others, meanwhile, will aim to achieve a certain amount of return, although they will usually still be bound by risk in some way e.g. through the Investment Association (IA) sector they sit in.

In the case of those targeting risk, this will be achieved mainly through varying the asset allocation; for example, if the fund’s risk level becomes too high then the equity proportion will be decreased and the amount in bonds and cash increased. Risk can also be varied by changing the weights of the underlying funds, putting more in ‘core’ funds (those that are highly diversified and following mainstream indices) and less in ‘satellite’ funds (funds with less holdings, higher performance targets and possibly more specialist in nature) in order to reduce risk.

According to our latest numbers, there are currently 310 multi-manager funds available to UK investors and 229 multi-asset funds investing directly in securities. In terms of assets under management, the corresponding total figures were £62bn and £122bn respectively as of late last year.

Following the Retail Distribution Review a few years ago, financial advisers now generally focus on suitability for their clients in the first instance. As part of this they will undergo a lengthy process of discovery with the client, looking at their goals and determining their attitude to risk and capacity to accept losses. One of the main outputs from this will be a risk score for the client, often on a scale of 1 to 10 or 1 to 100, with a higher number indicating a greater tolerance of risk. The task of the adviser is then to provide an appropriate solution based on this measure.

When considering investment solutions, many advisers will look at collective investment schemes and specifically multi-asset funds. But how can the adviser be sure that a particular multi-asset fund is suitable for their client from a risk point of view? As well as their new Volatility Managed sector the IA has four different sectors for multi-asset funds:

• Mixed Investment 0-35% Shares
• Mixed Investment 20-60% Shares
• Mixed Investment 40-85% Shares
• Flexible Investment

These give some indication to an adviser as to how risky a multi-asset fund might be; however, there can still be a great deal of dispersion within a sector. For example, within Mixed Investment 20-60% Shares one fund could hold 25% in equities while another could contain 55% and these would almost certainly give very different outcomes in terms of risk and return.

Another way of determining the risk and therefore suitability of a fund might be to look at the fund’s name. The Financial Conduct Authority (FCA), however, expressed concerns relatively recently over relying on fund names alone as a guide to how the fund might behave, due to inconsistency - e.g. what one provider says is Cautious, another might describe as Defensive. Instead, the FCA expect the adviser to dig much deeper or rely on independent firms with greater experience and resource in this area to help them do so.

As a result, a handful of firms including ourselves at Defaqto have launched risk ratings for funds, primarily multi-asset, over the last few years. These give the fund a rating, usually from 1 to 10, based on its volatility.

Defaqto’s Risk Ratings are reached by:

• looking at the fund’s past volatility (standard deviation) of returns over 1, 3, 5 and 10 years, where that data exists
• looking at the fund’s projected volatility using its asset allocation, both strategic (long term) and tactical (current), together with assumptions for the future returns, volatilities and co-movements of the asset classes it holds
• discussing these numbers with the manager of the fund, which gives us the chance to consider other factors, such as a manager or mandate change during the life of the fund, which the numbers alone might not capture

The perceived risk of each fund, normally the highest of the past and projected volatilities, is mapped onto a scale, where 10 is most risky and 1 is least risky, to give the fund its Defaqto Risk Rating. A multi-asset fund investing in just the main equity regions would receive a rating of 10 while a fund holding only cash would be risk rated 1. As might be expected, very few multi-asset funds have those extreme ratings, with the majority lying in the 3 to 8 range and the distribution of our risk ratings having a bell-shape.

Defaqto’s ‘Engage’ software for advisers has an integrated risk profiling tool that allows them to risk profile clients to ensure investment suitability. Defaqto supports a two stage process to determine a client’s agreed risk profile; first obtaining a ‘natural’ risk profile from the client by asking them to complete a psychometric questionnaire and then having a discussion with them to reach an ‘agreed’ risk profile. Their likely risk profile resulting from their answers and the discussion is represented on a scale of 1 to 10, where again 10 is most risky and 1 is least risky. The adviser can then match funds with a Defaqto Risk Rating corresponding to the client’s risk profile.

This helps explain the distribution of fund risk ratings outlined above - most people will have risk profiles somewhere in the middle-ground and relatively few will be at the extreme ends, therefore fund houses design their multi-asset funds accordingly.

Defaqto has currently risk rated around 400 multi-asset funds and DFM managed portfolios for advisers to recommend from when carrying out investment research, with this number still increasing all the time. Within Engage there is a ‘toolkit’ that advisers can access for further details about the risk profiles, our risk rating process and the rated funds in more detail plus compliance documentation to support advisers evidencing their recommendations.

It is worth noting that our risk rating of each fund is not a one off process. Every quarter we look at the newest numbers for the fund’s past volatility and asset allocation as well as the latest assumptions for the future returns, volatilities and co-movements of the asset classes it holds. If, on the basis of these, the fund subsequently appears more or less risky than its existing Defaqto Risk Rating suggests then, after discussions with the fund manager, we may well adjust the rating accordingly. Therefore an adviser can be confident that the fund will still match the client’s risk profile in the future or, if it is no longer suitable, they can move the client into another fund that is.

It is also worth remembering the difference between ‘risk targeted’ and ‘risk rated’ funds. ‘Risk targeted’ means a fund will aim to keep its volatility at a certain level or within a specific range, while ‘risk rated’ means that a fund has been assigned a rating based on its perceived risk, either by ourselves or one of the other providers in the market. Therefore, a multi-asset fund can be either risk targeted or risk rated, or be both or be neither.

In conclusion, multi-asset funds take the asset-allocation decision from the adviser, leaving the latter with the task of selecting the ‘right’ fund for the client, with suitability playing a large part in this. However, there are many different multi-asset funds on the market, with varying levels of expected risk and return and some methods for finding the most suitable ones for the client - relying on IA sector or fund name - can be very blunt. Risk ratings, though, are based on hard numbers as well as input from the fund manager and are much more precise, enabling advisers and their clients to see where a fund stands in terms of risk on a pre-defined scale, both on an initial and ongoing basis. This scale can be easily matched to the client’s risk profile.