Funds with high equity weightings may score as higher risk today, but could see their risk score fall as the relative volatility between bonds and equities changes
That means talking to a fund manager, finding out whether their portfolio is currently risk on or risk off, and therefore whether it reflects their long-term positioning.
At the same time, rather than risking fund ratings suddenly moving out significantly, the group reviews them every quarter to minimise “surprises”. Defaqto also uses the highest volatility as a starting point, which means its ratings tend to err on the side of conservatism.
Norwood admits there are problems in risk measurement today: “We have been through a period where volatility has been unusually benign. We deal with this by trying to be conservative, because we recognise advisers are dealing with client money and we would rather be safe.
“Once a fund is up and running, graded on a one to 10 scale, it goes into our Engage system and can be matched to a client’s attitude to risk or capacity for loss.
For example, a mixed-asset fund with a lot of fixed income may be a level five risk today, but could start to look riskier relative to its peers as market changes happen.
The same is true in reverse: funds with high equity weightings may score as higher risk today, but could see their risk score fall as the relative volatility between bonds and equities changes. Either way, it could throw out an adviser’s risk ratings for clients.This may be a particular problem where fund managers have avoided specific assets, such as gilts.
Gilts have looked expensive for some time and many multi-asset managers have stopped holding them on the basis that the risk reward is not attractive. This positioning could risk a significant ratings change as interest rates rise. That said, those who create the risk levels have put strategies in place to deal with this to some degree.
Defaqto investment consultant Patrick Norwood says: “We look at past volatility over the past one, three, five and 10 years. We make sure this is relevant volatility, so if a manager has changed halfway through, we wouldn’t include that portion. We also have a forward-
looking element. We take the asset allocation of a fund and apply a stochastic model, looking 10 years into the future.” The group also introduces subjective elements when applying its risk ratings.
Nicolas Trindade, CFA | Senior Portfolio Manager
fund manager profile
All risk-rated funds rely, to some extent, on the historic performance of assets to make a judgement on the type of risk they will pose to investors in the future. It is inevitably an imperfect system because – as the FCA is fond of reminding us – past performance is no guide to the future. Risk-targeted funds, meanwhile, analyse on the future – assumptions made with past performance of markets in mind. Both are systems that have worked reasonably well to date. But could this be about to become more problematic?
Since the global financial crisis, by and large, all assets have been supported by the liquidity created by quantitative easing. This has kept the volatility of even higher-risk assets such as equities at historic lows. In 2017, for example, volatility, as measured by the Vix index, was in a band of between nine and 12.
This compares with 60 at the height of the global financial crisis 10 years ago. Bond markets have been equally benign; the Merrill Lynch Option Volatility Estimate, which aims to track the implied volatility of US treasuries, hit new lows in July this year.This soft environment is changing, however. Equity and bond market volatility has spiked higher since September. While equity market volatility remains in the normal range, the bond market is currently showing its highest reading since 2012. This has a number of potential causes, from the unpredictability of the American administration, to higher oil prices and trade wars, but at its heart are rising US interest rates and a change in the global liquidity environment.
Relationships between asset classes are also changing. Again, risk ratings rely to some extent on historic correlations between asset classes – for example, a risk rating may say that bonds are low-risk and provide diversification to equities because that is what has happened historically. In this way, if a fund was part-allocated to bonds and part-allocated to equities, it could be said to be diversified and low-risk. Today, with the distortions created by QE, that may not be the case. QE has introduced liquidity into the system, which has pushed up all asset classes – something which has meant both the bond and equity markets are more correlated. Both may suffer with the withdrawal of QE. Therefore, simply using bonds and equities to achieve diversification might not work. Both may sell off together.
Square Mile head of risk-based solutions research Alex Farlow says: “If we get a slow and gradual unwinding of QE, any capital depreciation may be offset by the income from fixed income.
“However, if rates move faster than people expect, capital could reduce significantly. Safe haven bonds may not provide safety.” Is this necessarily a problem for risk ratings and the asset allocation models that rely on them? Will they pick up on this changing environment and adapt, or do advisers risk a suitability problem as risk parameters change?
Certainly, risk-rated funds are a snapshot in the life of a fund. This means that as the environment changes, that fund can move out of sync with its risk rating. A fund that is rated five today may be rated four or six the next time it is reviewed. The danger is that the adviser will no longer be recommending a fund that is suitable for a client’s desired outcome and attitude to risk. This is not a problem simply because volatility is changing. Risk ratings are in bands, so even if the market volatility goes up, a fund may stay in the same band. However, it can be a problem as the environment changes rapidly, as it is doing today, and the correlations between asset classes change.
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Choosing the right product for your clients
• Nicolas is a Senior Portfolio Manager within the London-based Active Credit team. He is responsible for managing both global and sterling credit portfolios amounting to approximately £2bn as at 31 January 2018. He is the lead portfolio manager of the AXA Sterling Credit Short Duration Bond Fund, AXA Global Short Duration Bond Fund and AXA WF Global Credit Bonds. In addition to his portfolio management responsibilities, Nicolas heads the ‘Sterling Credit Alpha Group’ during the Fixed Income department’s quarterly Forecasting Forum.
• Nicolas joined AXA IM in 2006. Prior to his appointment within the investment team, he was a Fixed Income Product Specialist responsible for the development of the UK, US and high-yield product ranges.
• Nicolas holds two Master’s degrees, one in Diplomacy and International Strategy from the London School of Economics and one in IT Engineering from Telecom Sud Paris. He is also a CFA Charterholder.
Surviving in turbulent markets
“The flow of
money created by quantitative easing has been artificially suppressing volatility, but this is coming
to an end.”
“We would flag it if it deviated significantly from the risk rating and would discuss it with the manager if there was a breach. Sometimes there is a bit of a breach, but it doesn’t go from three to five. It may move slightly.”
However, it does mean choosing a risk-rating provider carefully. Defaqto believes its risk ratings are robust because it uses a range of different sources and has quantitative and qualitative inputs. Distribution Technology also uses a commonsense approach.
Its methodology takes in historic volatility, but also brings in the current gilt yield, corporate bond yield, equity earnings and dividend yields, plus economic growth forecasts.
Farlow at Square Mile says: “There are different ways to skin a cat. Investors have to be careful of how risk-rating groups are using the assumptions and what is going into the process.” Some groups rely entirely on quantitative screening to determine their risk ratings. This may be inadequate to cope with a change in the environment.
If advisers want to avoid the problem altogether, risk-targeted funds can be a solution. Rathbones chief executive officer Mike Webb points out that all risk-rated funds rely on bandings: “The absolute risk could be high, even if it looks low relative to its peers, if everything is high. It is a problem for advisers, in terms of suitability and their liability, because they have a duty to assess ongoing suitability.”
He points out that with risk-targeted funds, as the equity market gets more expensive, the fund manager is forced to do something with portfolio construction that reduces specifically the risk of, say, equities. Here too, however, investors need to approach things carefully. If a fund targets a specific level of volatility, it may run into problems if overall market volatility rises. Over the past few years, for example, the level of equity market volatility has been extremely low. Those with an explicit volatility target could have loaded up with equities and still met their targets. Should the market turn, that “low-risk” fund would suddenly look very high-risk.
Rathbones’ funds instead target a percentage of equity market risk, so they will always be lower than the market, whatever the absolute level of risk. Webb adds: “With risk-targeted funds, you are committing yourself to a certain level of risk tolerance. You know the fund will always be managed in that way.” He believes we may be heading into a trickier time for risk measurement: “We’ve had a short period of volatility, but things haven’t really been tested yet.”
Advisers need to ensure that their risk measurement is sufficiently robust to cope.
Equity markets have continued their bull run, in spite of Donald Trump’s bombastic take on the presidency (or because of, if you believe his account). Bond markets have rather fallen out of favour; a shelter from the storm is all well and good, but in the public conscience, when an investment returns less than inflation, it’s like a shelter slowly filling up with water.
But there are signs that perceptions are turning. There are some very tough questions for active evangelists to answer when it comes to the fundamentals unpinning most equity markets. It’s not just the added security that should be a draw. When Treasury and emerging market yields are outstripping inflation, there is also an income case to be made in conjunction with the obvious benefits of a diversified portfolio.
There are plenty of fish in the fixed income sea. If anything, the market trends present a compelling case for further diversification, and diversification that should not be limited to asset classes outside of fixed income. As our contributors
for this supplement note, options in the strategic and absolute return sectors, as well as short and long-term durations, can often be overlooked.
Performance rarely lies, and not all managers are alike either. Some have clearly made bad calls, but others will make good ones that will be to the benefit of both advisers and clients. Be it by geography, duration, structure or yield, there are opportunities out there, however tough they are to find.
So, fixed income may be a tough sell, but one that still has a place in 2018, and the IFA community has a key role to play, with deep fact-finds and risk tolerance exercises helping to put a number on the right fixed income allocation for each client. If advisers want to stick to a traditional 60:40 allocation of equities and bonds, that is all well and good, but at a time where suitability requirements are being picked at with a fine tooth-comb, they would do well to illustrate why the rest of the options on the table did not suit their client’s needs.
Is it time for a reassessment of traditional models when it comes to deciding risk levels?
fund data profile
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Changing views of asset allocation
We have had a short period of volatility, but things have not really been tested yet
Income is another important consideration. Bonds were the mainstay for income portfolios for many years, but this has shifted as yields have fallen.
However, there are still parts of the bond market that pay attractive yields, such as emerging market debt. There is also the possibility that investors will return to the bond market as yields rise.
Lowcock says: “In the past few years of the bond bull market yields were getting incredibly low and in some instances negative, so this pushed income hungry investors into other assets, including equities and infrastructure. A combination of recovering bond yields and expensive valuations in those equities – tagged the bond proxies – has meant investors previously forced to buy shares have taken the opportunity to reverse that position and get the income they need at lower levels of risk.”
The 10-year Treasury yield is at over 2.7 per cent. This puts it ahead of inflation, meaning that investors are receiving a positive real return from government bonds. While UK and eurozone investors are yet to catch up, it is edging in that direction. The bond market may increasingly offer opportunities for income investors.
That said, although there are many reasons to hold bonds, any fixed income allocation in today’s market needs to be carefully managed. The risk profile of bond markets has changed and there are pockets of real danger. At the same time, most advisers do not feel confident enough to allocate between the different types of bonds themselves.
This is likely to be behind the popularity of strategic bond funds. These funds offer
the broadest exposure to the market and allow managers the flexibility to take advantage of changes in bond prices and yields as the markets adjust to an environment of rising rates.
Both Woods-Smith and Lowcock favour this approach. Lowcock likes the MI TwentyFour Dynamic Bond fund, which is run on a team basis, with each team member a specialist in a particular area of fixed income.
Overall, the bond market looks to be a more dangerous place at the start of 2018 than it was at the start of 2017. While there is no catalyst for a sudden sell-off, the slow grind higher of interest rates and inflation will influence returns from here, and is likely to threaten its status as a safe haven.
That said, the bond market is not without its opportunities. Not all bonds are alike, not all are exposed to the interest rate
cycle, and there are still diversification and income advantages. Advisers will have to work with their clients to show the merits of considering an allocation to bonds in today’s climate.