Warning on following asset allocation guidance of risk-targeting tools

An article published this week by FT Advisor, warned advisors of the risks associated with “blindly following the asset allocation guidance of risk-targeting tools”

Tim Myatt PhD
Author Tim Myatt PhD
Date 2nd May 2014

These “Risk Rated Funds” provide an easy-to-use solution for IFAs, and their popularity has increased in recent years. However, as convenient as it is to rely on a link between risk profiles and specific solutions, such approaches are likely to provide limited accuracy in determining suitable investments for individual investors.

Risk Investor Profilers, such as those provided by Oxford Risk, can accurately assess Risk Tolerance, and place respondents into Risk Tolerance Categories. Determining which investments are most suitable for investors in each of those Risk Tolerance Categories is an altogether more subtle exercise, and involves many different considerations. The FT Advisor article raises serious questions about methodologies that match Risk Tolerance Categories directly to Risk Rated Funds.

While parties are in agreement that volatility remains the most formative measure of risk for many assets and thus helpful in determining suitability, their first major concern is the critical influence that the time frame over which we assess the historical volatility of a given investment has on its ‘risk rating’. For example, data from FE Analytics show that in the past five years – which have presented a bull market for most risk assets – high yield bonds, as represented by the Barclays Global High Yield index, had an annualised volatility of 7.9 per cent.

However, if the time frame is shifted to seven years to incorporate the financial crisis, the index has a volatility of 11.2 per cent. This difference between the two volatilities would place the investment in very different Risk Rated Funds, depending on which time frame the advisor (or more specifically, client) chose.

Their second concern is that many investments or assets are at their least volatile just before a price bubble bursts and their value collapses. The article cites the example of property in 2007, which had very low volatility in the period leading up to the financial crisis.

Oxford Risk believes that while it is possible to ascertain the general preference for risk of individuals who share a Risk Tolerance Category, there are three main issues with seeking definitive suitable solutions from such analyses:

  • For any given risk tolerance category, the general preference for risk will vary for different time horizons, goals, etc. An algorithmic approach can be useful, but can only go so far in exploring the key components of risk capacity effectively. Furthermore, for any given risk tolerance category there will always be investors that are ‘outliers’. These outlier investors, through a combination of personal preferences or biases, will be better served by a different level of risk than that generally preferred by their risk tolerance peers. The article points out that advisory models which rely too heavily on such analyses will fail to adequately capture such instances, and thus offer unsuitable solutions.
  • Secondly, there is an issue of definitions: what is the appropriate foundation for asset allocation. Indices? Sectors within an index? Or should it be underlying stocks? Whatever the belief of the advisor or fund manager, translating overall risk preferences into asset allocations is a significantly difficult task, one which can be appropriately undertaken by an advisor, but is unlikely to be suitable when delivered by algorithmic solutions.
  • Lastly, investments that have an asymmetric risk reward curve, such as derivatives or synthetics, will require a suitability approach that has to be guided by an advisor, and can’t be approached either with ‘one size fits all’ asset allocations or through the use of volatility bands.

Oxford Risk’s approach to suitability is to ascertain a range of volatility that is preferred for each risk tolerance category, and factor into this the time horizon of the investment. This is similar to the perspective used in what the article defines as ‘risk targeted funds’ (as opposed to risk rated funds). Oxford Risk’s ethos is to provide our clients with information and understanding of investor tolerance of, and preference for, risk.

Therefore, our Time Dimensioned Risk Preference analysis is informed by the specific volatility ranges our clients want to offer. The decision of how a particular volatility target is delivered, and what the specific asset breakdown of those solutions is, remains in the control of our clients.

Last week we published an opinion piece that focuses on the recent developments in the direct-to-consumer market, and whilst it relates to non-advised services, it provides some insight into how to ascertain the general preference for volatility levels.

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