Our forward-looking volatility band for a risk profile ‘5’ is 8.3 per cent to 11.8 per cent with a target of 10.0 per cent.
A risk profile ‘5’ from another firm may have a band from 12 per cent to 14 per cent, so our risk-rated 5 will not align with the scheme from the other provider.
To return to the concept of blending solutions together at the same risk level, let’s look at two funds.
Both are risk-rated as ‘5’ (on our 1-10 scale). They both have very different asset allocations but they can produce similar projected volatilities, so are risk-rated at the same level.
However, they may actually behave very differently in various market conditions, despite delivering the same level of risk for the client.
As an example, I have taken two real funds that have the same Defaqto risk-rating and are therefore expected to deliver the same level of volatility, which the client has agreed to through an attitude to risk process.
The two funds have a different approach to their asset allocation, as shown below:
Net asset allocations | Fund A % | Fund B % |
Cash – (money market) | 4.4 | 0.2 |
UK Government Bonds | 1.9 | 3.8 |
UK Corporate Bonds | 7.9 | 20.8 |
UK Index Linked Bonds | 0.0 | 0.0 |
Global (ex-UK) Fixed Income | 13.7 | 28.8 |
Global Property | 1.5 | 0.0 |
UK Equity | 22.2 | 1.3 |
Europe (ex-UK) Equity | 7.4 | 20.1 |
North America Equity | 6.2 | 13.3 |
Japan Equity | 7.7 | 1.1 |
Dev Pacific (ex-Japan) Equity | 1.8 | 3.1 |
Emerging Markets Equity | 8.4 | 6.6 |
Absolute Return | 6.2 | 0.0 |
Other | 10.9 | 0.9 |
Total | 100.0 | 100.0 |
Source: Defaqto Engage to 17/6/19
Over the last three years they have a high correlation level of 0.92 per cent and have similar risk/return characteristics, as shown in the below table:
Fund | Annualised Volatility | Annualised Return |
A | 6.6% | 7.24% |
B | 6.5% | 7.48% |
Source: Morningstar Workstation 17/6/19
But, when we examine certain snapshots in time, we see very different behaviours.
While both funds delivered almost identical total return, for the period, the actual journeys were different.
Fund A performed well up until early 2018, with Fund B generally doing better until the end of Q1 2019.
So, combining the two funds within a portfolio would have delivered the same level of risk and return, but with a smoother ride in performance terms.
Going a step further, using data captured from Defaqto Engage, we know that advisers are also using core/satellite approaches at single risk profiles.
For example, 80 per cent of a recommendation may be made up of a single risk-rated fund and then the balancing 20 per cent allocated to a more esoteric solution, albeit risk-rated at the same level.
It should be noted that blending solutions rated at different risk levels to achieve a single risk-rating does not work, due to correlation issues.
For example, a risk-rated ‘4’ solution should not be mixed with a risked-rated ‘6’ solution to achieve a risk profile of ‘5’ outcome.
So, in conclusion, blending solutions of the same risk level can have some benefits, but additional effort is required on the adviser’s part to really understand what is going on inside the solutions they select.
Simply recommending several multi-asset solutions to increase diversity only works if the underlying assets are genuinely different and therefore increase diversity.
