Using a risk questionnaire on its own is good enough.
There are clearly two sides to risk profiling: establishing the investor’s risk profile and understanding the potential investment’s risk.
If these two things are done with the same risk definitions and boundaries, granular asset class assumptions and data definitions, your tool or process should be reliably translating and communicating the nature of risk from client to investment manager via the adviser on a consistent and granular basis.
With a professionally constructed and properly tested model, you should be able to articulate the range of likely outcomes to clients in a transparent manner where there is a shared language of risk and the client fully understands the potential likelihood and nature of making a loss.
Asset models and fund risk profiling is backward-looking, relying solely on historical volatility.
While this is true of the synthetic risk and reward indicators required in KIIDs, it does not apply to a good asset model or fund risk-profiling service.
When looking at a fund, one should consider first its current asset allocation exposure. That gives a view on likely potential strategic risks. We also look at the manager’s mandate and their ability to move into riskier asset classes as well as their track record of managing within a given risk profile.
Estimates for volatility, correlation and future returns by asset class are all factored in to any profile as well as looking at historical performance.
Risk profiling is the same thing as risk rating.
This may sound like semantics but the difference is important. While research firms rate which funds they feel will perform best in a particular sector or peer group and have built their businesses around this, risk profiling assesses investments on their risk alone
and should not attempt to rate a fund manager’s likely success or otherwise from a performance standpoint as there are many strategies managers can utilise to deliver their mandate.
What clients want first and foremost is a clear risk-return mandate set for any fund or portfolio they invest in.
This approach has been successfully used to manage institutional pension funds for many decades.
The key thing is to translate that mandate from the investor to the fund manager on a consistent basis.
Ben Goss is chief executive at Distribution Technology