The role of stochastic modelling alongside volatility based or qualitative research.
FT Adviser journalist Matthew Jeynes published a thought provoking piece on 29th April titled ‘Advisers warned of ‘dangerous flaws with risk tools’. The warnings were concerned with the reliance on volatility as the basis of ‘risk-targeting tools to build in-house propositions, reflecting on different aspects of the shortcomings of using volatility as a proxy for risk.
As Matthew's article points out, where such a uniform treatment of risk has been applied 'the methodology used by some… has 'flaws' that could direct low-risk clients into assets set to collapse in value'.
When you consider the overarching dominance of the couple of market leading solutions that have been adopted by the advice industry, you can appreciate that something of a systemic risk has developed. As Matthew’s article points out, where such a uniform treatment of risk has been applied ‘the methodology used by some… has ‘flaws’ that could direct low-risk clients into assets set to collapse in value’.
This is an area of concern for the regulator, fund promoters and advisers alike. Matthew highlights recent research from Iveagh in respect of risk-targeted funds, indicating that 40 percent of respondents had said that they had ‘developed our own in-house proposition, or intend to’. Not only are fund promoters uniformly aligning to the problematic risk rating services by default, adviser firms are building their own investment strategies in line with these frameworks. The risks inherent in such a ‘mono culture’ aside, it would seem the greater risk flows from the over reliance on the volatility based methodologies.
As reported by Matthew, experts in multi asset investing as diverse as Sarasin, Whitechurch Securities and Charles Stanley are adding to what are becoming increasingly well documented concerns over the reliance of Volatility as a proxy for risk.
In its various guidance around investment suitability, the regulator has highlighted the problems with over reliance on these tools, and puts the onus firmly on the adviser’s shoulders to demonstrate that they have recommended levels of investment risk that are appropriate to their client’s objectives, and just as importantly, that their clients fully understand and agree with the recommendation. Having therefore, a consistent and reliable measure of risk is essential to complete the recommendation, in a way that is ‘robust’, ‘repeatable’ and ‘reviewable’.
Synaptic have responded to this challenge by building an investment risk analysis and review tool, that accesses one of the most sophisticated risk engines in the market – the Moody’s Analytics (formerly Barrie + Hibbert) Wealth Scenario Generator, the market leading ‘stochastic engine’. The engine is at the heart of the Modeller tool, enabling the user to gain a view of investment outcomes, ensuring that the adviser can have an informed discussion of both growth and possible loss.
Leading distributors have embraced the advantages of a probability based risk model, sidestepping the challenges that over reliance on volatility pose. The stochastic model provides multiple economic scenarios, and the Synaptic software allows specific holdings or notional investments to be ‘projected’ according to the various asset classes that make up the investment. Following the logic that asset allocation drives performance, this tool provides a comprehensive view of possible outcomes.
Pressure from the regulator to evidence research used in the evaluation of investment risk is turning the spotlight onto the research commonly used. The volatility based systems tend also to be combined with a ‘qualitative’ overlay. This is where the ratings agencies ‘set’ a risk level based on their opinion. This absolutely may have its place, but cannot be considered to be an objective risk measure, based on transparent methodology. This is why we are promoting the stochastic route, to be used alongside a firm’s preferred ‘qualitative’ measures.
The Synaptic Risk Rating Service
This is a new service that offers advisers research and reports based on the stochastic outputs of the Moody’s engine. Subscribers to Synaptic have the ability to undertake this research using the Modeller tool, but the Risk Service maintains an updated range of investments, representing the choices of subscribers, including ratings on portfolio solutions from Providers such as Quilter Cheviot and Royal London.
The service is offered free, with the Synaptic Attitude to Risk Questionnaire. This generous offer is borne out of a key objective we have with our wider tool set, which is to increase the adoption of stochastic metrics. You can visit the site to register at risk.synaptic.co.uk.
Following the recent launch of the service, we have reviewed the format and included projections for both ‘strategic’ and ‘tactical’ asset allocations. Participating providers and their investments are included overleaf.
The Synaptic Modeller Risk Based Journey
As of next quarter, the users of Synaptic Modeller will have further options for conducting their research, following requests that portfolios built or distributed within an organisation can be projected within the Stochastic engine without going through the ‘rebalancing’ cycle within Modeller. This has been facilitated to streamline advisers’ access to the stochastic engine. Please feel free to request a demonstration.
- Pull preferred investment solutions, including portfolios into the research
- Probability and extent of loss (and growth) is quantified and represented graphically in easy to understand metrics
- Stochastic projections can be represented in different graphic formats
- Synaptic system allows analysis and reporting of portfolio asset allocation