A Mixed Bag

The investment advice industry in Ireland has gravitated over the last decade or so towards the use of Multi Asset funds, predominantly created by Life Companies for sale within their own pension and investment wrappers (this is known as vertical integration). These product ranges are generally labelled 1 to 7 in order to correspond to the ESMA risk rating. Many providers also utilise the ESMA labelling within their risk profile tools. So we often hear clients being described as follows “She is an ESMA 4 client”. The process then becomes one of matching an ESMA score from the risk profile to an ESMA score from the product range.

Are ESMA rating the right risk measure?

I won’t go over old ground here but suffice to say that many critics argue that the ESMA ratings are not a good measure of the actual riskiness of an investment product as they cover too short a time period (ESMA based on Standard Deviation of Weekly returns over 5 years). Just google “ESMA volatility bands Ireland” and you will see articles written by a number of industry commentators bemoaning the topic.

The resulting process of matching a client to a product based on the ESMA score of the product and the ESMA score of their risk profile result is a flawed process, yet the process continues unabated and this is the way a very large cohort of advisers appear to operate. Many seem to believe this is what the Central Bank expect them to do, however I have yet to see any such specific guidance from the Central Bank saying this.

Given the recent very large swings in the global stock markets as a result of COVID-19 and economies around the world being put into hibernation for public health reasons, I thought it would be interesting to look at the most popular multi asset products out there through the lens of ESMA.

What do the numbers say?

I have taken ESMA band 4 (5% to 10% volatility per ESMA) as the subject as it is one of the more popular ESMA bands in terms of assets invested.

As you can see from the chart below, over a 5 year period, there is a very wide dispersion of returns amongst all of these ESMA 4 products, ranging from a total return of 16% all the way down to basically zero. And, whether this performance is net of costs is a whole other question for another day.

Source: FE Analytics

When we look at max drawdown for Q1 2020, we see a similar picture emerge of very different journeys for clients depending on which ESMA 4 product they ended up in, ranging from -11% to -20%.

Source: FE Analytics

Remember, these are all multi asset products labelled as ESMA 4, and these are typically seen as more or less identical and interchangeable products, other than for say their investment approach e.g. active versus passive. The picture tells a very different story.

Investing is all about the journey, and if investors are experiencing a very different journey depending on which product they are in, this creates a tension where an adviser may be using various providers across their book of clients with varying outcomes as a result.

How do you choose between these products?

As an adviser firm how do you avoid the situation where all of your ‘ESMA 4’ clients end up with very different journeys (volatility and drawdown), and are arriving at very different destinations (return)?  And how do you explain it to a client who potentially holds two ESMA 4 products from two different providers but has ended up with 2 very different outcomes?

It highlights the perils of:

  • Risk rating clients using ESMA
  • Pigeon holing clients into a fund
  • Relying on product labels and in particular ESMA labels as a way of categorising or understanding funds

By partnering with an investment manager with a tried and tested risk separation methodology that relates directly to your client, volatile times should not be the cause of sleepless nights for you as an adviser. We have spoken about some of these issues before and for more in depth consideration of some of the issues around fund labels and risk profile mapping take a look at our whitepapers on “Unbalanced Risk Descriptions – Why Fund Labels cant be taken at face value  and “Risky Business – Why the regulator is right to be worried about risk mapping”