Benefits of risk rating Managed Portfolio services

06 February 2017

Fraser Donaldson – Insight Analyst (Funds and DFM)

Learning objectives – 

  • To refresh the client risk profiling process
  • To understand the benefits of risk rated MPS portfolios as well as funds when   building a client portfolio

Using risk ratings as a guide to what funds are suitable for the client is now a reasonably well established process, taking root in most adviser’s workflow some years ago. But, what about discretionary management?

Just as a reminder, when establishing a client risk profile, the following is considered:

  • Attitude to risk: what is the clients natural risk appetite? This is unlikely to change regardless of client circumstances
  • Capacity for loss: this may be at odds with their natural risk inclinations
  • Time horizons: important as short time horizons will make it difficult to recover from the occasional, some would say inevitable, market shocks. Required return (goals) here.will come in to the discussion
  • Understanding of the risks they are asked to take. The client does need to be educated in the process here. Without understanding, there is a danger that these formulaic results will not be challenged when necessary
  • Agree Risk Profile – based on natural risk level, capacity for loss, time horizon and required return

This system has had its flaws, as highlighted in the FSA (now FCA) final guidance paper FG 11/05 (Assessing suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection). Without going over old ground, both risk profiling tools and adviser practice were criticised. However, most of these criticisms have now been addressed and risk as a fundamental in the fund selection process is now well embedded in to most adviser’s workflow.

 

Regardless of the tools available and what are formulaic outcomes, engagement with the client is a must to establish if conclusions reached are suitable in reality. I rather like a comment from the FCA which said (and I am paraphrasing here) show the client what their risk profile is and what it means, don’t tell them”.

In the discretionary world, until recently, risk rating has not been part of the process. For bespoke portfolios this should not be necessary. The relationship between client and discretionary manager should be such that a suitable mandate for the client portfolio is set and the level of risk the manager is allowed to take should form a significant part of the discussion and be built in to the mandate.

However, until recently, managed portfolio service portfolios have not been risk rated which means that advisers have regressed to making judgements on risk based solely on the mix of equity, fixed interest and sometimes property (remember the mixed three-way portfolios!), or worse still the name of the portfolio – cautious, balanced, growth etc.

Lessons have long since been learned in the fund world that if something is called Balanced, this could mean almost anything as it is a very subjective judgement – one manager may believe this is 80% equity, another may see this as 40% equity and so-on. A little unnerving as with MPS solutions it is invariably you take on the responsibility for the suitability of the investment.

Managed portfolio service portfolios are essentially unwrapped multi-asset funds, so they should be able to benefit from the same risk rating process as funds. The good news is that now they do. Defaqto has been risk rating MPS portfolios for almost a year now and this has been welcomed by both DFM provider and adviser.

So, you can now reap the benefits of MPS portfolios being risk rated, putting them on a level playing field with funds in terms of the selection process. The most obvious benefit to risk ratings on portfolios is that client risk profiles can now be matched to suitable and appropriate portfolios based on their Risk Profile.

Portfolio ratings are based on a much more granular range of asset classes, not just the old fashioned equity/fixed interest and sometimes property split. Defaqto looks at 16 asset classes, differentiated by both type and geography. Each one has a different risk characteristic, so with the help of Moody’s stochastic model to forecast future volatility, together with analysis of historic volatility and a conversation with the portfolio manager we can apply a much more scientific approach to applying a risk rating.

As long as portfolio ratings are reviewed regularly, Defaqto review them quarterly, you can have much more confidence in the fact that the portfolio is continuing to do what it originally set out to in terms of risk taking. This is very useful knowledge to have at client review time.

The risk rating, whether at initial investment or at review time, creates an opportunity to engage with your client and have serious conversations about their goals, taking in to account the Risk Rating of the fund and what the likely outcome in terms of performance is.

The conversations with your client around the risk ratings will all contribute to educating them, giving them a greater understanding of why you are making the recommendations you are. It puts some logical reasoning behind the advice given, which can only increase the trust the client will have with you.

Just a small warning here in that some funds and portfolios are designed to remain within a risk band, commonly known as risk targeted – you would expect their risk rating to change rarely. There are risk focused funds where there are no risk targets set, but risk management is fundamental to the investment process – again, risk ratings should change rarely but perhaps more often than risk targeted.

Finally, there are portfolios that are designed to achieve as much alpha as possible. These may not have a strategic asset allocation target, running to a much shorter term tactical asset allocation. You can risk rate these funds but expect the rating to change more frequently. These funds may not work for advisers who are bound to a risk rating process. However, there is something to be said for investment professionals deciding when is the best time to take risk and the best time to take risk off. This kind of approach would have to be appropriate for the client though.

The change to a risk based approach may seem a bit dull to those advisers who enjoyed the thrill of trying to pick this year’s winners for their clients, but clients by and large are more concerned about securing their futures and achieving their goals without any disasters along the way. Everyone sleeps well at night.

 

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