Risk targeted versus risk rated versus risk allocation funds

14 August 2014

Frank Potaczek, Head of Insight and Consulting (Investments)

To show you exactly how this fund terminology is generally applied, we've compared risk targeted funds with risk rated and risk allocated funds.

Risk targeted versus risk rated funds

Risk targeted and risk rated funds generally look similar to traditional multi-asset funds. They are sold as a fund range that includes higher and lower risk offerings. Primarily they are differentiated by the measurement of risk.

Risk ratings are generally provided by a rating agency, and based on the information available at the time of the assessment. A rating assessment can be done for a risk targeted fund, so they are not mutually exclusive.

The need for a risk rating of a risk targeted fund, however, is not obvious. More typically, they are applied to traditional multi-asset funds, whose mandates are designed to keep the fund within one of the Investment Management Association Mixed Investment peer groups.

The manager of a risk rated fund aims to outperform, subject to the guideline asset allocation constraints. There is no requirement to keep risk within a target range, and a risk rating could change at a subsequent review. Risk ratings are not standardised, so users of these ratings need to be clear on the rating methodology.

The mandate of a risk targeted fund requires its manager to stay within a guideline risk range, normally measured by a volatility band. This means that the manager will normally have to reduce exposure to riskier assets if the upper volatility band is hit, and to add to risk assets if volatility moves to the lower band. Asset allocation may therefore be more flexible, which is the main reason why risk targeted funds are not marketed within the IMA Mixed Investments peer groups (which require adherence to the asset allocation ranges of each sub-group). The guideline tolerances are manager-specific, and therefore the investor, or their adviser, needs to know the investment approach to staying within the relevant volatility band.

Risk targeted versus risk allocation funds

Risk targeted and risk allocation funds have mandates that require the manager to meet a risk objective, typically measured by a volatility level or band.

As mentioned above, risk targeted funds are managed off portfolios that generally look the same as those of traditional multi-asset funds, but the portfolio manager adjusts the asset allocation and fund/securities selection to stay within the mandated volatility band.

Risk allocation funds are managed in accordance with an investment process that starts with risk-parity (each asset is equally weighted by contribution to overall portfolio volatility) as its neutral position. Advocates of risk parity say that all asset classes perform equally per unit of risk over the long term, and therefore have the same Sharpe ratio. In practice this means that risk allocation funds will have more in low risk assets, such as high quality bonds and cash, and less in equities than a traditional 'balanced' multi-asset fund.

Risk allocation funds are also sold in families, with each member having a different volatility target. However, in contrast with risk targeted funds, the asset allocation is the same for each family member. The volatility target is met by using more leverage in funds with higher volatility targets. In practice leverage is achieved using futures contracts rather than borrowing.

The manager of a risk allocation fund is also required by mandate to control the fund’s volatility directly. Compared with a risk targeted fund, they will not adjust the asset allocation to stay on target. Instead, they will reduce leverage if volatility increases and vice versa.

Fund popularity

Risk ratings have become popular with advisers looking for a simple way to meet due diligence requirements. Risk targeted funds have the additional benefit of satisfying ongoing suitability.

Risk allocation funds have gained popularity globally on academic studies showing that low risk assets perform as well as high risk assets (helped further by the volatile environment of 2008), and that portfolio efficiency could therefore be improved by applying volatility rather market-cap weightings. However, they have not yet had a significant impact on the UK market, where the RDR has been an important driver, and risk allocation funds do not do anything more to help advisers meet its requirements than risk rated and risk targeted funds.

Defaqto Ratings

Our Diamond Ratings cover risk targeted fund families. Through the Ratings, Defaqto helps advisers, and their clients, see at a glance where a fund or fund family sits in the market based on both performance and a range of key qualitative attributes.

In addition, our risk mappings help advisers match suitable multi-asset risk-bound funds with their clients’ mandates. The risk mapping service uniquely maps fund family members to Defaqto’s 10 risk profiles. A risk mapping of 1 indicates that a proposition represents the lowest risk profile; a risk mapping of 10 indicates the highest risk profile.

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