Read more from Morningstar's Managing Risk Week here.
It should come as no surprise that risk, investment or otherwise, is unavoidable. Accepting a certain level of risk exposure is a prerequisite for entry into equity or bond markets, and generally the greater the potential return, the greater the potential risk involved. That said, completely foregoing investment risk by not investing is for many of us as implausible as limiting the risk of a traffic accident by not leaving the house.
Rather than trying to avoid investment risk altogether, a sensible approach to investing involves fully understanding your tolerance of risk, the risks inherent in your portfolio and how to keep a handle on them. In order to help you attain this goal, we’ve outlined some key risks below. This is in no way an exhaustive list, but it serves to provide a brief overview of some of the main ‘risks’ and ‘returns’ of investment vehicles and styles.
Let us expand a little on some of these key ‘risks’.
Active and Passive Investing
One of the chief distinctions between active and passive investing, from a risk perspective, is exposure to alpha. Simply put, beta describes the market return while alpha measures the difference between an investment’s return and that of its benchmark. The promise of an active fund manager is to deliver returns higher than a chosen benchmark, and it is this promise that is used to justify active management fund fees. Passive funds, such as exchange-traded funds and tracker or index OEICs, do not seek alpha. Instead, their promise is to replicate the return of a certain index and for this reason their costs are lower. Thus, an active manager needs to generate returns over and above the benchmark plus their fees in order to make investment in their funds worthwhile for the client.
This is, however, an over simplistic picture of how the risk profile of active and passive funds differs. Passive funds, by virtue of being index trackers, are usually more transparent than active funds, which should allow an investor to better assess the underlying assets and risks to which their portfolio is exposed. That said, index funds are complex structures that employ a number of different approaches to replicate their chosen benchmark and can subsequently suffer from tracking error. That is, they require a dose of careful due diligence or, if you will, ‘educational risk’. Finally, while exchange-traded products, by virtue of being traded on a recognised exchange, give easy access to illiquid assets such as commodities or precious metals, they are also exposed to trading speculation and exchange volatility.
Open-end and Closed-end Funds
Within the actively-managed funds space, open-end and closed-end funds also expose investors to a distinctly different set of risks. OEICs, for example, are open to unit subscription and redemption, thus allowing investors to withdraw their money in a market downturn or buy into a strong fund. The latter, however, is a double-edged sword; as OEICs increase their asset pool through subscriptions, a manager might be forced to purchase holdings beyond their strongest convictions or at an inopportune time. Similarly, in the case of multiple redemptions, a manager could be forced to sell out of assets during a market downturn despite sentiment to the contrary.
CEFs are not exposed to such pressures. However, the closed-end structure forces investors to retain underperforming shares in cases of limited market liquidity and suppressed demand. In addition, the nature of CEFs’ trading discounts and premiums means these vehicles can be more susceptible to market sentiment than fundamentals, with investors snapping up shares in a fund that trades at a discount without due diligence as to the suitability of that fund for their portfolio. Concerns over CEFs’ level of transparency has also been cause for debate lately.
A feature specific to the CEF structure, and one generally considered an advantage of these products, is the presence of an independent board. In addition to the fund’s manager(s), a CEF’s directors are also entrusted with the responsibility of delivering returns for investors. Another feature specific to CEFs is that of gearing—something that has caused some investors to shy away in the past but which can also present opportunities.
DIY Investing
While stock-/bond-picking might suit those individuals with a strong understanding of their chosen markets, and the time to conduct in-depth research, accessing various sectors and markets through a collective investment scheme broadens the scope for diversification and lowers the due diligence burden for individual investors.
Ultimately, an investor’s choice between stock picking and fund investing is dependant on their own capacity and limitations. Similarly, whether the investor goes it alone—in stocks or funds—or employs the portfolio construction and management skills of a professional is down to personal taste, knowledge, and financial needs. We’ve discussed at length the perils of taking a short term approach to investing and too frequently reallocating assets, and DIY investors will find a wealth of independent research, commentary and investment tools on Morningstar.co.uk. Successful investing also relies heavily on a comprehensive understanding of one’s financial goals and a healthy dose of self discipline—seeking professional help in this area can certainly help protect the individual from their own behavioural risks.
