What's in a name?
Alex WhiteHead of ResearchAsset & Liability Management
“What’s in a name? That which we call [risk] by any other name would [cause a headache].”
Admittedly, I don’t think Shakespeare could ever have imagined his famous words being shoehorned into an article about types of fund risk ratings. But in this case, there’s a lot in a name. Does ‘risk’ mean volatility? Is it backward-looking or forward-looking? Is it Value at Risk? Or is it based on historical stress tests? You get the picture; there’s much at play beneath the umbrella term.
For most financial advice firms, a client’s risk assessment is a critical step in their advice journey. It’s the foundation for ensuring any recommended products and investments are suitable and aligned with the client’s goals, circumstances and, importantly, feelings. As tools to help advisers with both risk assessment and subsequent alignments have proliferated, so too have funds designed to map neatly to risk bands.
How risk is defined and distilled into a score, usually a rating from one to five or one to 10, can make a material difference to client outcomes. While the benefits of this rating approach to client, adviser and regulator alignment are well understood, it can lead to problems, especially when the methodology is too dependent on a single risk metric. In particular, if a profiling tool changes a fund’s risk band (from, say, band four to five), advisers with clients holding portfolios targeting band four will be notified, potentially triggering a switch to an alternative band four portfolio. The downside is that fund managers have a strong incentive to stay within risk bands, potentially at the detriment of following their investment convictions – risk methodology tail-wagging the investment process dog.
Strategies like Diversified Growth funds (DGF) and Multi-asset Credit (MAC) make dynamic allocations between asset classes and regularly shift between buckets based on their views of market opportunities. It’s essential for these strategies to look at risk through multiple lenses. While commonplace in pension scheme investment strategies, they have made less traction in the wealth market, potentially because, by nature, they won’t map or remain consistent with most risk profiling methodologies used in this space. At Redington, we like these types of funds and their ability to implement their best ideas without constraint.
As mentioned above, using a single risk metric can backfire. Here’s an example of how:
Suppose the chosen risk metric is 3-year rolling volatility, and a manager is buying high-yield bonds. The overall volatility since 1999 has been 10-11%, so let’s suppose the manager will reduce their allocation when rolling volatility reaches 12% – what would that have done to performance? Left alone, excess returns on the index were 4.1%; but by reducing allocations after a fall (i.e., when spreads were higher), the returns fall to 3.2%, losing 0.9% a year, or c.20% of the returns. And while the risk is lower (9.4% against 10.3%), the difference in the risk reduction is smaller than the returns lost and the Sharpe ratio is worse.
As mentioned earlier, there are many ways to look at risks. The table on the following page highlights some of the trade-offs involved with different metrics. What jumps out is that all metrics have plenty of flaws, so the best way to build a robust portfolio is to use multiple. At Redington, we typically start with Value at Risk (VAR); this is a statistic that quantifies the possible losses within a portfolio or position over a specific timeframe. Our calculation measures the loss that would be incurred in a worst-case scenario over the next year – the worst case is often assumed to be a 1-in-20 event (VaR 95). We think it’s critical to look at this alongside other risk lenses like stress tests, sensitivity analysis and long-term projections.
That’s harder to automate and needs judgment around how much to weight each risk view, but it’s necessary. Look deeper at your chosen methodology, challenge the assumptions and, if you need any help determining what’s in a name when it comes to your portfolios and outcomes, we’re here to help.