How to interpret risk targeted funds over time

01 July 2015

Patrick Norwood – Insight Analyst (Funds)

Evaluation of risk targeted funds over time should focus firstly on how closely they have kept to their risk target because they are marketed to investors as products with a pre-defined, stable risk profile. Secondly, the focus should be on how well they have performed compared to similar funds.

That sounds simple, but there are a number of issues to consider, such as what time period to choose to measure risk and return. Which funds should you compare them with? How much leeway should you give a fund that is off target? How do you judge the risk management process? Has there been a change in the portfolio manager or a key team manager, and if so, what are the implications?


The most popular measure for targeting is volatility (or standard deviation in statistical terminology), typically within a range. It is not possible to control fully the volatility of a portfolio of securities or funds as their prices are market determined and there's a lot of randomness (or ‘noise’ as its sometimes referred to).

However, there's a mean reverting pull towards the underlying fundamentals of the portfolio as you extend the time period. In a normal market cycle five years is long enough for this to take effect and it therefore it seems reasonable to expect a fund's manager to keep actual volatility within the target range over rolling five-year periods.


The performance of a risk targeted fund is best measured against the average of a peer group of risk targeted funds with the same volatility band or bands that overlap. So how many funds do you need for reliable interpretation? Many say that 30 is considered statistically meaningful, but you can get away with fewer, probably as low as 10.

If you need to make up the numbers, you could include some risk focused funds (see our recent article on the difference between risk targeted and risk focused fund families) as long as their risk parameters are similar and their historic volatility over a cycle has been in line with the peer group of risk targeted funds.

Building a useful peer group is ultimately a trade-off between ensuring that you are only comparing apples with apples on the one hand and including a sufficient number to be statistically meaningful on the other.

While you should give leeway to funds whose actual volatility is outside of the target band over short periods (particularly during exceptional market conditions), it's still fair to monitor for volatility deviating by more than what would be expected of a fund with decent risk management. Within a meaningful peer group, it may be worth investigating the risk management of a fund that consistently displays high levels of volatility over the short, medium and long term.

Questions you may want to ask the fund manager

Questions to ask of the investment process and risk management include:

  • What is the portfolio’s maximum exposure to equities?
  • What are the exposure limits for other risk assets such as sub-investment grade credit, commodities and private equity?
  • Is there a limit on the aggregate of risk assets or a minimum reserve of defensive assets like ‘safe’ government bonds and cash?
  • Do these limits look compatible with the fund's risk target?
  • Are there any course correction tools such as value at risk or rules on selling risk assets if volatility rises beyond a specified threshold?

One issue with course correction tools is that they force the manager to sell risk assets when they are cheap and allow them to buy more when they're expensive, which is questionnable investment logic.

So you should be aware that overreliance on course correction tools can be at the expense of long-term returns in all but the strongest trending market conditions. However, anticipating market changes instead of just reacting to them is easier said than done.

A good manager may get this right 6 out of 10 times and back their judgement just enough for it to have a meaningful effect on the fund’s annualised return, but not so much that in the times when they're wrong volatility is blown way off target. Such managers often have a strategic asset allocation that is compatible with the volatility target, while making tactical adjustments based on current valuations and an assessment of market conditions over the next few months.

While controls on exposure to risk assets and course correction tools are things to watch out for, even more important is that whatever the investment process, it's applied consistently.

To judge this you need to look back at what the manager has done over time and monitor the fund going forwards.

When evaluating a risk-targeted fund over time you should also pay attention to team member changes, particularly if there's a change in the fund manager or anybody else who takes decisions on the fund. The typical risk-targeted fund will be a bit more process-driven and less about a star manager, because the management group is selling a risk-controlled process. However, loss of the manager or another key decision-maker will still put a question mark over the reliability of past performance and success in meeting the volatility target going forwards, even if it doesn't make it totally irrelevant (as may happen when a star manager with sole decision-making responsibility moves off an actively managed fund).

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