The financial crisis undermined many long-held doctrines in asset management. For example, the synchronised fall in the major asset classes countered the benefits of diversification espoused by traditional portfolio theory.
It was not surprising that the financial crisis caused a lot of investors to lose substantial amounts of money in risky “pure” equity sectors such as emerging markets and smaller companies but the losses incurred in the cautious managed sector were significantly higher than many investors expected.
Investors in such funds had presumably expected their assets to be managed in such a way as to avoid the worst impacts of a financial crisis. Yet the average maximum peakto-trough loss in the sector was more than 21 per cent over the last three years.
As a result of these losses, there has been a rethink in the industry as to just what the term cautious means.
Much of the thinking has been that the solution is to reduce the maximum equities exposure limit, for example the Investment Management Association cautious managed sector allows up to 60 per cent equity exposure. Some have argued it should even be as low as 30 per cent. However, this detracts attention from the problems of why cautious managed funds lost as much as they did and the issues that must be faced to find a solution.
The FSA said in its finalised risk guidance paper in March that investors’ perceptions of the risk posed by the category description have been largely misunderstood and that one firm’s research had indicated that their customers thought the risks posed by certain investments were higher than they would have expected from a category using terms such as cautious.
Calls to redefine the IMA definition of what qualifies as a cautious fund have also overlooked an important factor – just what does the term mean to investors themselves?
We asked investors and, as far as they are concerned, if they are in a cautious managed fund then they do not expect to lose more than 9.5 per cent of their assets in a three-year period. Interestingly enough, 89 per cent of investors also described their attitude to risk as low to medium.
IFAs have expressed scepticism towards the cautious managed sector, too. IFAs told our independent researcher that they will not recommend 28 per cent of cautious managed funds because they think they are too risky, even though they are positioned as low to medium risk. Eleven per cent of IFAs will not recommend over half of the cautious managed funds available to UK retail investors because they are too volatile.
It is crucial to understand the impact of volatility on performance. There is a very strong link between volatility in a fund and losses. Analysis carried out by RBS on the cautious managed sector over the last five years shows the correlation between volatility measured over 12 months and maximum loss was 0.84, where 1is a perfect correlation.
IFAs are also right to have concerns about cautious funds. During 2008, the cautious managed sector was extremely volatile, with many funds increasing their volatility threefold during that period. Cautious investors suddenly became balanced or even adventurous without ever realising it. The market volatility led to over 40 per cent of funds within that particular sector losing more than a quarter of their value over the last three years.
Investors need to understand volatility and not be led by the funds’ names and potentially the sector a fund is necessarily in. Investors and IFAs should consider volatility and the potential threat of losses, and an investor’s capacity for loss, as important factors when it comes to making investment decisions.
Having established that the cautious managed sector has surprisingly made losses beyond the expectations of investors, would a low exposure to equities have avoided significant losses? Even here, the evidence shows the answer is a resounding no. We found that even those cautious managed funds with 30 per cent or less exposure to equities had an average maximum loss of 16.8 per cent, still way beyond the 9.5 per cent expected by investors.
The evidence suggests that reducing the extent of possible losses in an investment is not simply about having limited exposure to equities over the long term. What is key is having a dynamic strategy in place to know when to increase and decrease exposure to equities and other asset classes.
When equities are going through performance-decimating volatility, a 60 per cent, 50 per cent or even 30 per cent limit on exposure is not necessarily the right solution. The only exposure that makes sense is one that continues to match the risk profile of the investor.
Yet research by Morningstar demonstrates just how unresponsive many cautious managed funds were in the financial crisis.
Between October 31, 2007, and February 28, 2009 – when equity markets fell by around 50 per cent – over 80 per cent of the funds in the cautious managed sector with assets of more than £50m (80 funds) adjusted their equity exposure by just 20 per cent in absolute terms.
Half of the funds adjusted their exposure by less than 10 per cent. This was at a time when the annual volatility of the funds soared from 4.2 per cent to 13.5 per cent.
Unfortunately, investors sometimes make the mistake when they find their investments in a market trough of selling out of their holdings. By buying high and selling low, they can miss out on the market recovery.
In our view, the issue for the cautious managed sector is to offer a product that goes some way to controlling volatility.
This was the rationale behind the recent launch of our volatility-controlled cautious and balanced funds. We believe one solution to these problems is to use an investment process with the flexibility to radically adjust exposures to asset classes when required and in proportion to market volatility.
The acid test will be if investors believe in volatility as a concern that will continue to exist in some shape in the future. But this is a genuine attempt to give cautious investors what they want. Our industry should always remember that is what matters.