Adjusting for risk

03 August 2017

Pan Andreas – Head of Insight and Consulting (Funds and DFM)

Post Retail Distribution Review, the focus for advisers is generally on client suitability. To determine suitability, they will follow a process of discovery with the client, looking at their goals and determining their attitude to risk and capacity to accept losses. One of the main outputs from this will be a risk score for the client, often on a scale of 1 to 10 or 1 to 100, with a higher number indicating a greater tolerance of risk. What follows is for the adviser to provide an appropriate investment solution based on this measure.

When considering investment solutions, many advisers will look at collective investment schemes and specifically multi-asset funds. In addition, adviser demand has led to DFMs also risk rating their model portfolios.

But how can the adviser be sure that a particular multi-asset fund or DFM model portfolio is suitable for their client from a risk point of view?

The FCA expect the adviser to obtain a deep understanding of how the fund might behave or to rely on independent firms with greater experience and resource in this area to help them do so. As a result, Defaqto have introduced Risk Ratings for funds, primarily multi-asset, over the last few years. These give the fund a rating, usually from 1 to 10, based on its volatility.

To reach the Risk Rating, Defaqto looks at:

  • the fund’s past volatility (standard deviation) of returns over 1, 3, 5 and 10 years, where that data exists and
  • the fund’s projected volatility using its asset allocation, both strategic (long term) and tactical (current), together with assumptions for the future returns, volatilities and co-movements of the asset classes it holds taken from Moody’s stochastic engine

The results are then discussed with the manager of the fund, which ensures a common understanding of our process, but also gives us the chance to consider other factors, such as a manager or mandate change during the life of the fund, which the numbers alone might not capture. The fund is then given a Risk Rating.

Once decided upon, the Risk Rating for that particular fund is published on Defaqto Engage, an investment planning solution for advisers. Engage has over 17,000 funds, of which 500 are risk rated and a vast amount of data available for use during the research process. It covers fund performance, risk adjusted return ratios and costs which advisers can use to filter, sort, rank and analyse the options to make the most suitable recommendations for their client.

The integrated risk profiling tool hosts a number of third party psychometric questionnaires that assist advisers in risk profiling clients to ensure investment suitability. It does this by a two stage process to determine a client’s agreed risk profile: first obtaining a ‘natural’ risk profile from the client by asking them to complete a psychometric questionnaire and then having a discussion with them to reach an ‘agreed’ risk profile. Their risk profile is represented on a scale of 1 to 10, where again 10 is most risky and 1 is least risky. The adviser can then match funds with a Defaqto Risk Rating corresponding to the client’s risk profile.

It is worth noting that our rating of each fund is not a one off process. Every quarter we review each Risk Rating and monitor those that are drifting towards the assigned level’s boundaries. If a fund crosses into another Risk Rating then, after discussions with the fund manager, the fund will be put on watch and, if the shift is persistent, we may well adjust the fund to a more appropriate level and pro-actively inform all advisers of the change.

Therefore an adviser can be confident that the fund will still match the client’s risk profile in the future or, if it is no longer suitable, they can move the client into another fund that is.

You can find out more about risk profiling and fund selection within Defaqto Engage's accumulation workflow.

This article first appeared on Janus Henderson Global Investors.

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