Now more than ever, it’s a good idea for advisers to look further than ratings to fully understand how investment funds align with their clients’ specific risk profile.
Ratings provided by independent agencies are a brilliant starting point for advisers working to determine the risk profile of different investment funds, both on and off-platform.
But, it’s important that they are seen as that – a starting point – because, for example, independent risk ratings don’t typically take into account the smoothing mechanisms used by some funds when assessing risk.
Risk ratings are useful as they provide a single metric that allows an adviser to assess a potential investment at a glance. But, while ratings provide a fast and cost-effective way to determine suitability and meet regulatory requirements, they often don’t tell the whole story.
Clients’ circumstances change and funds’ activities evolve over time, and most independent ratings are reliant on the allocation of equities to determine a fund’s risk rating.
With this in mind, it can be sensible to use ratings alongside other considerations.
Smoothing mechanisms and volatility
Wesleyan’s With Profits Growth Fund aim is to provide capital growth over the medium to long term by investing in UK and international equities, bonds, property, cash and other related investments.
Alongside this, it uses a smoothing mechanism, which works to deliver steady performance by holding back some returns when market performance is strong, to support consistent returns through periods when the market experiences losses.
It helps to reduce sharp day-to-day fluctuations in price to achieve the steady growth that will suit investors who don’t have a large capacity for loss.
This fund maintains a moderate-risk score from several independent agencies, however these tools do not consider the smoothing mechanism.
FE fundinfo risk scores are a key indicator that can be used alongside risk ratings which don’t consider smoothing, as this measure is based on actual historic volatility. They are a simple tool designed to enable investors and advisers to measure the risk of an entire portfolio or its constituent elements.
Wesleyan’s smoothed With Profits Growth Fund has a FE fundinfo score of just 9 out of 100 (as at 27 Mar 24), and it has been consistently low historically, not having exceeded 15 out of 100 in the past 3 years. This is extremely low when compared to its sector benchmarks. For example, the FE fundinfo risk score for the 'ABI Mixed Investment 40-85% Shares GTR in GB' sector has tracked between 50 and 70 over the same period.*
Despite this low volatility, the fund has delivered cumulative investment returns of 70.39% over the last 10 years to 31 December 2023, compared to 63.46% for the 'ABI Mixed Investment 40-85% Shares GTR in GB' sector benchmark.*
This performance illustrates how smoothed funds can be an effective way for investors who have become more risk averse in recent years, to still benefit from investing in equities.
Assessing risk in the current climate
In the current climate, other factors beyond risk ratings based on asset allocation feel more important than ever. So, what can advisers assess to better understand the true risk profile of different funds?
Maximum drawdown can give a clear idea of the possible losses an investor could experience in times of high market volatility or poor investment performance. While it has some limitations, it can provide realistic insights into the potential risk for clients and the losses they may face during different investment periods, making it useful for risk comparisons.
During periods of market volatility, it’s even more critical to make sure that clients’ portfolios are diversified, both within asset classes and across asset classes, which risk ratings on individual investments don’t always reflect.
Exchange-traded funds and mutual funds are well understood as an effective way to diversify portfolios, without having to select and buy individual stocks.
And smoothed With Profits funds can be a powerful tool for advisers to further mitigate investment risk, for the reasons already outlined.
Capacity for loss
When advisers are working to match a clients’ risk preference with a suitable product or portfolio, paying close attention to capacity for loss is a good idea.
Shortcomings with questionnaires that some firms use to gather information from clients include poorly worded questions and unsuitable weighting of answers. This can mean advisers, for example, don’t appropriately identify that clients should be increasing cash allocation because they don’t want or can’t afford to lose any capital.
Even when the client’s risk preference is assessed correctly, the recommended product or portfolio – and the underlying allocation of assets – does not always fit.
This is a message that the regulators have been hammering home for some time now, and it is even more important at the moment, with market volatility looking likely to continue.
In summary, it’s important to remember that while ratings are a helpful way for advisers to give clients an indication of risk, there are other factors that are worth considering alongside them, as they don’t always fully represent the level of risk, particularly in the case of smoothed funds.
Those who take the time to look beyond risk ratings and assess all the information available will be able to create truly bespoke portfolio of investments for their clients, not just an off the shelf selection.
* FE fundinfo