Cockerill: Beware risk-rated funds
The analyst says that classifying funds according to the risk they take on distorts managers’ incentives.
Fashionable risk-rated funds discourage managers from making investment decisions that are in the best interests of their clients, according to Rowan Dartington’s Tim Cockerill (pictured)
The Retail Distribution Review (RDR) requires advisers to analyse the risk appetite of their clients and many wealth managers have responded by launching funds that target factors such as volatility. FE Trustnet reported yesterday
on the large number of such funds that have opened this year.
However Cockerill, head of collectives research at the firm, is sceptical about the value of such funds, claiming they incentivise managers to produce results that aren't necessarily in the clients' best interests.
"We get clients asking us to create portfolios to certain statistical variables like volatility, max drawdown and so on, but you end up trying to hit the statistical targets rather than looking for opportunities," he said.
"Investment is about allocating your money and buying things which achieve what you want to achieve, but this seems to be leading things in a very different direction."
"Also, you are building everything around statistics, which by their nature are historic and will be different in the future."
"I think in a few years you won’t see any more of these risk-targeted funds."
However Graham Bentley (pictured)
, head of propositions at Skandia, rejects these claims.
"Industry myth tells you that the relative risk assessment of each asset is made on historic data, but this is not true," he claimed.
"On our Spectrum range of funds the ratings are based on what we see happening for the next 10 years in the future, updated every three months."
According to Bentley, research shows that the risk ratings of asset classes relative to one another tend not to change.
He says the basic features of equities – that investors are buying a future income flow – and bonds – which have a maturity and a promised return – determine their relative riskiness.
Skandia uses its projections to show clients the percentage chance of their returns falling within a certain range.
Bentley claims this means clients can then make more informed decisions on what their returns are likely to be, within certain time-frames.
Cockerill thinks one of the biggest problems with these risk-rating models is that there is no uniform measure of risk in the industry.
"Different people have different ways of creating risk profiles which they work to and we often find they aren’t easy to compare," he said.
"You can argue KIIDS is an industry-wide standard, but I do not think it works in an adequate manner and sometimes it seems like reverse engineering – you end up tweaking the portfolio to fit into the bands."
Key Investor Information Documents (KIIDs) were introduced earlier this year and display risk ratings with a value between 1 – indicating the fund takes on the least risk – and 7 – indicating the highest level of risk.
Cockerill says this distorts the incentives for fund providers and makes them aim to hit a band rather than produce the best product.
"Another flaw with KIIDS is that you are going to get a lot of funds bunched up with a rating of 5, 6 or 7 but there will be considerable differences between those funds," he explained.
While he accepts that new trends do sometimes fit investors’ needs, Cockerill warns fund houses often jump on the bandwagon to meet their own interests.
He points to the Schroder Small Cap Discovery fund, which was opened earlier this year, as an example of an innovative product being launched for the right reasons.
"Schroders said: 'We can see good value in small caps in emerging markets and we have a manager with good experience so we are launching a fund.'"
"It was driven by investment reasons and not because they were jumping on the bandwagon."