Risk targeted funds are attracting considerable attention in the UK marketplace. It’s not hard to see why this is the case. Investors and those who advise them are sure to find appeal in the ostensible certainty of being able to quantify and thereby contain their risk. Therein lies the problem, however, and unless due care is taken, it’s one that could have significant negative ramifications for investors, advisers and asset managers down the road.
Risk is a slippery term. Investment professionals often take as a measure of risk the volatility of returns as expressed by standard deviation. They might also express it as the risk of gains forgone, or of erosion of capital due to low returns in an inflationary environment, the risk of not meeting a specific investment goal, etc.
Thus, when a fund bills itself as risk-targeted, the first question anyone should ask is: what risk? In many cases, risk is defined by such funds within absolute volatility bands, e.g. Santander Atlas Portfolio targets 5.5% volatility with lower and upper bands of 4.25% and 6.75%, respectively. This is not an uncommon approach. Another approach might target a per cent of the volatility of a given benchmark, as Rathbones does.
A considerable body of evidence, however, has shown that investors greatly prefer avoiding loss to earning gains. Put more practically, people have an outsized fear of losing money. Standard deviation of returns, which does not distinguish between upside and downside variance is, in this light, a sub-optimal measure of risk. Further, it is a view into the past, which is all too often not prologue.
This mismatch is exacerbated by the tendency of targets such as the above to provide investors with a feeling of precision and control over the risk of loss that could be misleading. How misleading? It bears remembering that market volatility had trended down for years before the financial crisis of 2008.
The three-year annualised standard deviation of MSCI World in USD terms was just 7.65% at July 31 2007—this was the absolute lowest level for volatility for the index in any monthly rolling three-year period as far back as 1970.
Between November 2007 and end February 2009, the same index plunged 54%. In other words, just when its volatility was at a nearly 40 year low, the index fell off a cliff.
The lesson is that volatility can be a poor proxy for the risk of loss (this is one of several reasons that we view the SRRI indicator required on KIIDs to be generally unfit for purpose). One might argue that such events are extreme, but this is not a credible counter. Indeed, the very moment at which investors will most be counting on funds to control risk for them will be when the danger is greatest, i.e., precisely during such extreme events.
Further, such events are not as rare as one might think: Indeed, Laurence Siegel of the CFA Research Institute found no fewer than 11 instances of asset classes losing 49% or more since 1911.
Irrespective of the above, it’s worth keeping firmly in mind that a fund’s risks are ultimately defined by the securities it owns. To the extent you own other investments, your portfolio level risk is characterised by the interaction between all of the underlying securities—an effect that cannot be captured in a product-specific risk target and which may render that target meaningless in a portfolio context.
We also note that funds may reserve the right to reset volatility targets and can lack clarity about their willingness to tactically re-allocate assets to stay within their risk target. We think the trend to multi-asset investing is good, largely because we think such products are easier for investors to stick with through time, but would caution investors not to ascribe much merit to the notion of a risk target as a means of controlling risk of loss.
This article previously appeared in FT Adviser magazine
