How can you compensate for the risk you expose your clients to by fund managers that do not follow the risk profile of their fund mandates? The simple answer is that you can't.
It is almost a truism that fund managers have a tendency to spend most of their time trying to beat the competition in the short term rather than concentrating on the long-term performance of their fund. Thus they often leave their funds overly invested in high-risk shares or equities.
This, at least, is the contention Scottish Life is making to attract IFAs to its managed funds. It claims to have slashed its holdings in equities and says it is looking to better manage client's risk over the lifetime of the funds.
Scottish Life head of business development Graham Dow says today's fund managers are following a herding instinct that under present conditions cannot easily be changed.
He says: “They tend to only look towards their quarter or six-month results and where they sit in the ratings rather than the life of the fund. This means the exp-osure to risk through equities can become substantial over time.”
Dow believes managed funds no longer offer a full diversification of assets. He says: “The average equity exposure in the ABI balanced managed fund sector is 81 per cent with low levels of exposure to property – an asset class important for many savers.”
Scottish Life says it is combating this by putting in new frameworks that ensure its three managed funds will target specific levels of risk over the short, medium and long term.
By constructing its three funds in such a way, Dow says Scottish Life is able to significantly calm IFAs' fears that they are subjecting their clients to unnecessary risk due to fund managers not fulfilling their mandates.
This, he says, has been one of the biggest problems faced by IFAs. “If your risk profiling shows that your client has high aversion to risk and you select a fund accordingly, how do you know that the fund will stay appropriate without constant sup-ervision? Our new funds are structured so that you can be sure your client is getting what they expect.”
ISIS fund of funds director Richard Philbin agrees that fund managers can tend to herd. However, he says sometimes this is for a very good reason: “There is a reason why certain types of funds do the same kind of things because their allocations are usually what is right for the fund.”
Philbin adds: “Scottish Life's announcement seems to be saying: 'Expect high differentiation/inefficiencies over the market norms but do not be nervous because it is part of a long-term strategy.'” Essentially, Scottish Life is now offering risk-defined funds with lower weightings in equities and believes it is the first manager to address the problem of creeping risk by restructuring its managed pension funds to target specific levels of risk over the short, medium and long term.
The three funds offered by Scottish Life – the adventurous fund, managed fund and the defensive fund – are to be modified to fall under new mandates set up to fulfil three different risk profiles.
The new mandates have been set up by an investment committee – comprising senior management from Scottish Life and sister company Royal London Asset Management – which will review the funds on a quarterly basis to make sure they are continuing to perform as expected.
In practical terms, the modifications will mean Scottish Life will dramatically cut equity ratings for its managed and adventurous funds.
Its defensive managed fund will remain the most cautious fund in the range, restructured as low risk for short-term investors close to retirement. It holds 21 per cent in equities at present but this will increase to 28 per cent alongside dramatic increases to its index-linked gilts and modifications to its holdings in five-year corporate bonds.
The managed fund will be seen as a medium-risk fund for investment over around 10 years. Equity exposure will be cut to 55 per cent and fixed-interest holdings will increase from around 13 per cent fixed interest and index-linked gilts to 18 per cent in 10-year corporate bonds and 10 per cent in 10-year index-linked gilts.
For those wishing to take higher risks over the longer term, the adventurous fund will decrease equity holdings from 99 per cent to 75 per cent, with the rest of the fund holding 18 per cent property and eight per cent 15-year corporate bonds.
Many investment IFAs are seeing the new structure as a suitable way of helping to realise their client's appropriate risk profile. However, there are sceptics. Hargreaves Lansdown head of research Mark Dampier admits he is not a great champion of funds that are managed via a risk profile. He says: “This should be the job of the IFA. If the IFA does not understand what the client needs then what are they good for?
“The City is full of fund managers that are short termist. This is why investment IFAs need to keenly und-erstand the needs of their clients and operate accordingly.”