Your clients expect you to deliver a decent return for them, but they also expect you to do so within their risk parameters. There are plenty of investment propositions available that seem to offer solutions but, surprisingly, there isn’t a widely accepted framework that you can use to easily evaluate and compare their risk-adjusted returns.
Fund names are supposed to indicate the risk levels of particular funds. Unfortunately, grouping funds by categories such as ‘balanced’, ‘growth’, ‘cautious’ or ‘defensive’ in order to compare returns is pretty useless because there is no common agreement what the names mean, and the individual fund groups decide the name.
Unsurprisingly, balanced funds with more equities will tend to do better than those with less equity in them in rising markets (and over the long term). But they will also be riskier, so not necessarily better in the risk-adjusted sense.
Obtaining robust performance figures comes with its own challenges, as does using volatility measures. More detail on this is outlined in a recent paper I’ve written called Unbalanced Risk Descriptions. It’s available to download free from the PortfolioMetrix website by clicking here.
Accepting there are some challenges in obtaining performance data and volatility measures, once you do have them how then are you supposed to compare risk-adjusted returns? We recommend using a simple scatter chart.
As a comparison tool, it covers most bases. It’s easy on three counts:
comparing risk and grouping funds/models with similar risk levels (regardless of whether some are called ‘balanced’ whilst others ‘cautious’ or ‘aggressive’)
comparing returns of funds/models with similar risk levels
evaluating when risk rated ranges offered by model providers aren’t providing a consistent risk/return trade-off in their different funds/models.
I’ve included a chart that demonstrates the power of the framework by looking at PortfolioMetrix’s entire UK risk range against the UK’s 20 biggest multi-asset ‘Balanced’ funds (data supplied by Financial Express) over PortfolioMetrix’s track record since inception to 31 August 2019.
PortfolioMetrix Models are shown after all investment fees including underlying fund costs and PortfolioMetrix fees. Balanced fund returns of ‘master units’ as per Financial Express. Data source: Financial Express. Past performance is not a reliable indicator of future performance
What’s most obvious from the above is the spread of risk of so called ‘Balanced’ funds (from under 6% to over 10%), as well as the general relationship between risk and return. What is also easily noticeable using this framework is the outliers – those portfolios that have delivered the best, and worst, risk-adjusted returns.
To summarise, fund and name descriptions like ‘Balanced’, ‘Cautious’, ‘Growth’, ‘Adventurous’ are only useful for end clients once an adviser has used a framework like the scatter chart to ensure that the fund/model being recommended is actually consistent with its descriptor from the risk perspective, and that it has historically delivered robust returns commensurate with the actual risk it has taken.
A version of this article previously appeared in The Trade Press publication – FEIFA April 2018