What to consider when it comes to fund suitability

11 September 2018

In this article we cover how to align portfolios to individuals and the differences in fund selection approaches, as well as why different models work differently for risk profiles.

Elements of this article were originally published in FT Adviser.

Paul Tinkler, Insight Consultant (Funds and DFMs)

There are many things to consider in respect of fund suitability, not least the importance of aligning risk profiles and risk rated funds.

It is also important to understand how to align risk profile asset allocation models and portfolios, as well as knowing which fund features could be considered for fund suitability.

So, what is the best way for advisers to select suitable funds for their clients?

Choosing a fund

Clearly there is no straightforward answer to this question, as it’s like saying “what is the best car for a person to buy?”

In the same way that choosing a car is determined by very different individual needs and motivators, selecting the right fund, or funds, for a client will be driven by a variety of factors, from both an adviser and client perspective.

If I extend our car analogy a little further I can think about consumers that may want a car for a variety of uses, such as running the kids around, taking stuff to the rubbish dump and collecting furniture from IKEA.

There are many risk profiling tools in the marketplace but they all have very different risk characteristics.

Clearly the vehicle that meets those requirements is going to be very different to a two-seater convertible sports car that is suited to whizzing down country lanes on a hot summer’s day.

I can then look at funds, or investment solutions, in a similar way.  Advisers, in my experience, may offer one, two or all three of the following solutions to their clients:

  • One and done: Single-risk or return-focused funds. Maybe akin to the ‘does everything’ vehicle, highlighted above.
  • Fund picking: Adviser-managed model portfolios. Maybe akin to more focused vehicles, such as off-road 4WD and sports cars.
  • Outsourced: Discretionary fund manager (DFM) model or bespoke portfolios. Maybe akin to a chauffeur driven limo?

That’s probably enough of the analogy for now, and what I’m really suggesting is that selecting a suitable investment solution comes down to client suitability and the adviser's business model.

In this article I’m going to focus just on the first two solutions on the above list and leave DFMs out of scope for the time being.

Picking the fund

If we think about the ‘one and done’ approach then I would suggest the adviser needs to be thinking about a variety of aspects such as cost, simplicity (or complexity), potential for outperformance and, probably the most important, suitability of risk.

For example, if a client’s requirements are for low cost simplicity then a passive solution would seem a suitable option, with costs generally being lower than an active solution, with, generally, an index tracking strategy.

However, if the client is looking for the potential to outperform indices then an active approach may be more suitable, albeit with higher costs and more complex structures.

Obviously the active vs passive debate rumbles on and will never have a final resolution as different strategies perform differently in different market cycles.

This is why many advisers opt for the middle ground of recommending blended active/passive solutions.

Now, let us think about the risk aspect and I’m going to assume that, today, virtually all advisers use a risk profiling process within their business.

This process will probably be using some sort of questionnaire to obtain a starting point for a client’s attitude to risk.

This should then lead to a discussion about the potential investment outcomes and associated risks. The client’s capacity for loss should also be captured at this time.

At the end of the above process, it is likely that the client and adviser will have settled on a specific risk profile, probably between one and 10 (other ranges are available).

Challenge

The next challenge is to identify an investment solution that matches that profile and, if opting for a ‘one and done’ solution, then it’s absolutely vital that the risk profile and the risk rating of the solution are aligned.

There are many risk profiling tools in the marketplace but they all have very different risk characteristics, even if they appear similar, with, say 10 risk levels.

However these levels will use very different risk boundaries, usually defined using annualised volatility bands.

Let’s look at a hypothetical example of two risk profilers and their volatility boundaries for their risk profile 5s:

If the adviser were using ‘A’, then a suitable fund would have to be risk rated with an expected annualised volatility of between 8 per cent and 10 per cent, which would be in line with ‘5’ for that profiler.

However, if the adviser were using ‘B’ then the same fund would not be volatile enough for ‘5’, as the expected annualised volatility needs to be 10 per cent or more to equal a ‘5’, so in that case the same fund would probably be rated as a ‘4’.

So, it is clear from this basic comparison that fund risk ratings and risk profilers cannot be mixed and suitable funds must use the same rating basis as the actual risk profiling tool.

Aligning risk

If we then think about aligning risk profiles to adviser portfolios (the ‘fund picking’ approach), then there are some different challenges.

Most risk profiling tools will produce a range of optimised asset allocations that the providers believe will produce outcomes in line with the risk and return characteristics of their risk profiles, based on various market assumptions.  

For example the Defaqto Engage Risk Profiling Tool currently uses the following optimised asset allocation for a Risk Profile 5 portfolio:

 

But, again, because all risk profilers are different the optimised asset allocations are also different.

Let’s look at two different providers' asset allocation models, both of which are available in the marketplace, for a risk profile 5.

Both are looking to produce a risk profile 5 experience for clients but one splits out the UK Fixed Interest, has a much higher allocation to non-UK equities and allocates to commodities.

It needs to be made clear that neither of the above is wrong; they are just different, as they are aligned to different levels of expected risk and return and based on different market assumptions.

So, obviously, in the same way as the ‘one and done’ funds, advisers should use the asset allocation models, or the volatility boundaries produced by their risk profiler of choice to create and manage their model portfolios.

I’d also suggest that the risk profiler should have a portfolio analysis tool that will check that the portfolios created by the adviser exhibit expected risk and return characteristics in line with the risk profiles, by looking inside the funds to ensure the fund assets are aligned to the fund name and objective.

For example, large amounts of cash within a fund, which may be a tactical decision on the part of the manager, may skew the risk characteristics of that fund.

A good portfolio analysis tool will take that into account and reflect that across the portfolio.

Obviously not all risk profilers provide this functionality and advisers should then consider using an additional stand-alone portfolio analysis tool to check the asset allocation and/or projected volatility levels of their portfolios, albeit at additional cost.

Once suitability for either a ‘one and done’ or ‘fund picking’ approach has be established there are some further aspects that the advisers could consider, when selecting the actual funds.

Purely as an example, at Defaqto we use the criteria, as part of our Diamond Ratings process, which looks to rate funds based upon where they sit in the market, considering both performance and a range of key attributes, including the following:

Criteria

  • Group AUM - Size of group AUM is an indicator of total resources available to the fund, such as research, risk management and compliance.
  • Fund size - Funds that are too small to be economic are likely to be closed, while funds that are too large will find their size impacts on investor returns due to liquidity and market impact issues.  Critical fund sizes vary from sector to sector.
  • Manager tenure - Managers with greater experience of managing a fund are a likely indicator of achieving fund objectives in future.
  • Domicile - Funds registered within Great Britain will enable investors to access the Financial Services Compensation Scheme (FSCS) if necessary.
  • Ongoing charge - Lower costs will be less of a drag on performance.
  • Sharpe ratio - Better past risk adjusted performance might indicate better future risk adjusted returns (total risk).
  • Rolling Sharpe ratio - To measure the consistency of risk adjusted performance across multiple time-periods (total risk).
  • Calmar ratio - Better past risk adjusted performance might indicate better future risk adjusted returns (downside risk only).
  • Counter-party risk - A counter-party with a high financial strength rating is more favourable than one with a lower financial strength rating. Using multiple counter-parties is better than one or two, as the risk is spread.
  • Capital Batting Average - A fund that experiences a permanent fall in capital may find it more difficult to generate income in future.
  • Delivered Yield - Funds that have delivered high yields to in the past may continue to do so in future.
  • Income Volatility - Funds that deliver more consistent dividend distributions will be more useful for income investors.
Choosing suitable investment solutions can be a complex business and creating a cohesive investment proposition can be a genuine challenge.

However, hopefully the above has provided some high-level thoughts on the subject.

Engage Core

You can learn more about our end-to-end financial planning tool or request a free trial here.

You might be also interested in our other Insight articles.

Disclaimer: The Defaqto risk scheme, asset allocations and Diamond Ratings are subject to change, due to regular ongoing reviews.

 

Share this