Investments  

Role of DFMs in managing risk

This article is part of
Discretionary Fund Management - July 2015

Outsourcing to a discretionary fund manager (DFM) means that risk profiling is usually carried out by the adviser using a third-party or the DFM’s own tool, and clients are placed in a risk bucket relevant to a particular model portfolio.

But how is risk managed within the portfolio, and where do the responsibilities between the adviser and the DFM lie?

Parmenion Investment Management has 12 strategies, and within these there are 10 risk grades that automatically create 120 potential portfolios.

Article continues after advert

Based on risk-profiling results with information added by the adviser, asset allocation is defined by risk grade and the maximum gain or loss is shown.

While this process involves selecting investments to populate each asset class, it’s up to the adviser to choose whether they want active or passive exposure within these parameters.

Parmenion chief investment officer Simon Brett says there is a quarterly review, where it “makes sure all the risk grades are performing in line and so the more risk taken, the greater the return”.

Mr Brett justifies the ability to stay within the risk parameters and achieve the yield as a result of flexible tactical asset allocation.

“We use maximiser funds within these portfolios, because of their high yield, but with a limit of 35 per cent in any of the risk grades,” he says.

“We review the portfolio and target the yield quarterly.”

Rowan Dartington has a different approach, where a live system flags up any inconsistencies outside the set parameters where risk is first defined by a limit-to-equities exposure.

Investment director Tim Cockerill says: “We have five risk profiles and each of these has a risk budget. For the highest risk level, 100 per cent could be exposed to equities and for the lowest there is a limit of 32.5 per cent.”

It is not just the asset parameters that are defined, but every investment used or on the system is categorised as one to five in terms of their risk profiles, which is based on a mixture of quantitative analysis and subjective opinion.

Mr Cockerill says: “Using quant analysis, high-yield bond funds tend to come out as risk level two. I tend to rate them at risk level three because I’m more interested in their future potential for volatility, rather than what they’ve been displaying in the past few years, [which is] where most of the data is taken from.”

Correlation of fixed income was an issue flagged by the latest Portfolio Barometer, a review of 147 risk-rated model products run by UK financial adviser and wealth management firms, analysed by Natixis Portfolio Research and Consulting Group.

It found that many fixed income categories held by conservative funds were highly correlated with each other.

Head of research Matthew Riley explains: “Advisers should be aware of flexible fixed income manager high correlations, both among themselves and to corporate managers. Adding two, three, or more flexible managers may have led to increased risk in portfolios if fixed income markets take a turn for the worse.”