How many definitions of risk do clients discuss with IFAs – inflation risk, interest rates, markets, default, liquidity, event, tax, legislation, manager, principal? Probably none other than the “Am I going to lose money?” risk.
The problem facing people wanting to invest is the situation regarding risk or what precisely makes one investment more “risky” than another is harder to define.
There is significant evidence to show that the use of past performance tables provides little value when selecting an investment. An increasing amount of data, notably from the FSA in August 2000, has shown that there is very little chance that a top-quartile fund manager will be able to repeat the feat over the next five years. Success, it appears, is based upon a combination of market timing, stockpicking and luck.
If success is so difficult to repeat, the concept that one fund is more risky than another, when the chances of either achieving prolonged upper-quartile growth are so slim, becomes redundant. The majority of funds have equal risk because they offer no definable characteristic to make one more volatile than the other. This makes fund and, therefore, risk differentiation all the more difficult.
The notion that most funds are very similar is old hat to IFAs but still has fund managers up in arms. Endless pie charts and lists of their unique research methods and remarkable ability to get fund performance right can be produced and manipulated when required but the vast majority of unit-linked funds across a peer group invest in the same stocks.
If the fund make-ups are, broadly speaking, the same, then the effect of general market volatility will be the same. How can IFAs and investors differentiate between funds and fund managers to achieve their goal – more money with an understoo
d level of risk?
In August 2000, the FSA paper by Mark Rhodes into past performance highlighted the problems faced when preparing a risk profile. The normal techniques for assessing a fund or sector's performance reliability are flawed.
As Mark Rhodes put it: “Losers repeat, winners don't.” If this is the case, then the risk factor when picking any investment fund is always high. With this in mind, risk becomes a much less precise science than avoiding the Far East.
To make it more straightforward, the factors that can be used to control actual risk need to be defined so that investors are more educated about the decisions they make.
Benchmarking can be as simple or as complicated as an investor wants. A comparison to the FTSE 250 or S&P 500 provides a general indication of risk against a set marker of volatility. More sophisticated methods of risk measurement using benchmarks such as beta variance, value line, standard deviation and downside risk may also be valuable.
Beta variance is possibly the most useful. Widely used in the US, it allows the volatility of a fund to be benchmarked by number. For instance, if a fund has 1.2 beta variance, a benchmark (FTSE 250) move of 10 per cent would be expected to produce a 12 per cent move in the fund value.
It provides a means of assessing risk without the use of standard past performance tables, which are open to excessive manipulation.
Impact of cost
Trading cost can make a great impact on risk, regardless of the fund holding. As there is a cost to buy and sell any stock, managers could also increase the impact of volatility against a benchmark if they over-trade.
If this happened, it would increase risk regardless of market volatility. Legislative drives to reduce fund charges can help but old fashioned reduction in yield is still the defining pressure to reduce cost risk.
Diversification is not as easy as it sounds. With so many funds occupying the same ground, there can be little to choose from if difference in stock holding is the only measure of how funds differ. Strategy and other “soft factors” come into play when creating the different parts of a sufficiently diverse portfolio.
Is the fund top-down or bottom-up? Does a team or a shining star liable to leave manage it? How has it performed among its peers against a suitable benchmark? Is the risk level significantly different from the other parts of the portfolio? Does it now match the risk/reward profile of the client?
When diversification takes place according to the above questions (and many more), risk can be controlled in a much more rigorous fashion and the IFAs client is sure of the added value they have received.
This does not mean having a paid fund manager in charge of the fund. Many fund managers get paid very good salaries for extremely mediocre performance. This adds to risk because it increases uncertainty for the investor. This is where experience and the value of advice come into play.
IFAs know which fund managers can cut the mustard and which cannot. Reputation attracts successful managers and creates momentum. For an investor, management risk control needs advice and IFAs are the most suitable to provide it.
Every investor should know time is the great leveller of risk.
But time, while reducing the impact of volatility, does not guarantee good returns and so investments need to be monitored to assess how they are performing against a suitable benchmark. IFAs and investors can then be reassured that while the potentially disastrous effects of volatility (risk) can be lessened the pressure to achieve good returns is maintained.
The overall goal of managers should be consistency. A fund that produces upper-quartile results over a 15-year period will produce very good returns for any investor. According to research and the FSA, it will also have outperformed the vast majority of its peers.
For investors, the risk is not knowing whether their investments will make money regardless of asset allocation, location or risk category. When the new comparative tables are produced by the FSA, the IFA will still be the key to shaping portfolios and helping people feel secure with any risk they take.