The adviser guide to risk-targeted multi-asset funds

Risk targeted multi-asset funds look set to continue to grow in popularity. However, due to the speed of innovation and evolution in this area, some advisers are struggling to find the time to keep up. As a result, some confusion has started to creep into the market place over the features and benefits of these types of funds. This article aims to provide a bit of clarity around some of the key topics.

Index fund based risk-targeted multi-asset funds may provide a cost-effective solution for advisers seeking to support clients who might otherwise not be able to afford advice – in other words, they could be the solution to closing the 'advice gap'.

Risk rated versus risk-targeted

Some of the industry press coverage of these funds fails to clearly differentiate between a fund that carries a basic risk rating and a fund that is actively risk-targeted, but there is a world of difference between the two.

Any fund can receive a 'risk rating' from a (preferably independent) risk profiling agency. However, very few funds have an explicit mandate or process to maintain this rating. Normally, funds have other targets, such as delivering income or outperforming a benchmark. Over time, they can succeed or fail in meeting these targets, but either way, they could, and often do, drift away from their original risk rating. This poses a challenge for advisers who must continually reassess whether or not the fund remains suitable for a given client and aligned to their risk profile.

In contrast, a 'risk-targeted' fund aims to maintain its risk level, or match a specific risk profile, over time. The managers of these funds aim to build a portfolio that delivers strong risk-adjusted returns while remaining true to a particular risk profile. Doing this successfully requires the fund to adapt over time by adjusting the asset allocation in the face of developing trends. Even as the markets cycle through the inevitable bull and bear phases, the risk profile of a risk-targeted fund should remain fairly consistent. This allows advisers to align the risk attitude of their clients to the funds' and hopefully avoid any nasty surprises.

Delivering performance versus managing volatility

Risk-targeted funds should aim to deliver the best return possible within stated risk parameters. Performance is therefore fundamental to managing such strategies. The risk-targeted element serves to provide advisers with the comfort that the strategy will remain aligned to their clients' risk profile.

Volatility is simply one measure of risk, which misses out other portfolio risks such as inflation risk, illiquidity risk and active manager risk to name but a few. Ultimately, the main risk that investors are interested in is the risk of losing money and risk-targeted funds must seek above all to generate the best possible long-term return within their risk parameters.

Index versus active components

One look at the IA sector performance shows that multi-asset strategies with an index fund bias are not the ones languishing at the bottom of their peer groups. Active funds certainly do have the potential to outperform, but it does come with a definite cost penalty attached which can detract from their utility as a component of a multi-asset portfolio. They tend to be more expensive than index funds, and due diligence can be an expensive and often resource-intensive exercise.

With investors and regulators increasingly focusing on fund management costs, demand for cost-effective multi-asset solutions has never been higher. Investors increasingly understand that costs will inevitably detract from overall performance.

Proactive risk targeting versus blindly following a risk profile

Different risk-profilers have their own strengths and weaknesses, making sweeping generalisations difficult. However, blindly following a risk profiler could lead to sub-optimal outcomes. There is no 'right' way to determine the correct asset allocation to meet a given set of investment objectives. Risk is a multi-faceted problem and has to be analysed in a number of different ways. The key is to do so smartly and not just rely on a simplistic view of past performance to guide future investment decisions.

People sometimes fall into the trap of assuming that markets follow a normal distribution, such as the classic 'bell curve' commonly used in statistics. One of the lessons from the 2008 financial crisis, however, was that it's possible to rely too heavily on risk models that are based on these simplistic assumptions. At times of stress – which is exactly when you need them the most – these models tend to break down. In the real world, risk doesn't obey rules.

One way to make historical data more useful is to look at what 'might' have happened, not just what 'did' happen. A robust strategic asset allocation process will do this by random sampling 'slices' of data from different periods of market history, re-ordering these again and again to create thousands of variations that 'could' have occurred historically. Each slice preserves the relationships between asset classes at the time, allowing for more rounded and detailed analysis of those relationships.

The rise of risk-targeting

Risk-targeted multi-asset funds represent the next generation of multi-asset investment solutions, and it's no surprise that they have seen significant inflows and a plethora of launches. The concept is still a relatively new innovation for multi-asset funds and understanding will improve over time and therefore will no doubt deepen. With increased competition among product providers, these are exciting times for investors who should ultimately benefit in the form of stronger risk-adjusted returns and products that meet their needs.

Index fund based risk-targeted multi-asset funds may provide a cost-effective solution for advisers seeking to support clients who might otherwise not be able to afford advice – in other words, they could be the solution to closing the 'advice gap'.

In addition, if these funds succeed in being consistent with specific risk profiles, the adviser and their client will both have peace of mind that, as long as the client's attitude to risk doesn't change, the funds should remain suitable.

This is not a consumer advertisement. It is intended for professional financial advisers only and should not be relied upon by private investors or any other persons. 

The value of investments and any income from them can fall as well as rise and is not guaranteed. Investors may get back less than they invest. 

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