‘Risk doesn’t matter…until it does.’
This is one of my own quotes. What I mean is that as long as an investment/fund is performing well, investors generally don’t look at the risks/volatility being taken. It’s only when performance turns down that investors then focus on what risks/volatility were being taken and by then it is too late if higher than expected risks were being taken.
Anyone who has an investment portfolio, Pension, ARF, Trust, a medium to long term savings plan or lump sum investment, is likely to have undergone a risk profiling exercise which will identify your tolerance for risk for that portfolio. This will have matched your tolerance for risk and your time horizon to your requirement for growth and income, and given you a score, typically from 1 to 7.
Your money should then have been invested accordingly.
The majority of risk-rated funds/portfolios are built around the ESMA scale, which was developed by EU regulators (European Securities and Markets Authority) for UCITS funds. This scale (from 1 to 7) is based on the volatility of a fund’s returns over the past five years. Greater volatility implies a higher risk level (loss potential), but also better return potential. Here’s a chart of the ESMA scale:
So, for example, a fund with a ‘4’ rating (medium risk) could expect to experience a fall of between 5% to 10% in a down market.
Now a fund’s risk rating should not be the only indicator whether a fund/portfolio is suitable for you or not. Your risk appetite should also take into account what you are saving/investing for, your time horizon for the investment, your liquidity needs, etc. Most people know that if you are investing for retirement over a few decades that you should be prepared to take a high level of risk to improve the longer-term returns. But if you are saving for your children’s education fees 4 or 5 years from now you should probably only take a medium amount of risk.
Many experts would say that the ESMA risk rating system is flawed. ESMA 1, 2 and 3 span expected movements in value between 0% and 5% (refer to ESMA chart above). So, three bands (out of a total of 7) cover only 5% expected movements. The next band, ESMA 4, covers a 5% range in just one rating level, it spans 5% – 10%. ESMA 5 is again a 5% band ranging from 10% – 15%, but ESMA 6 then doubles its range!
And the volatility range is ‘expected’; actual range can be different (worse) in sudden market falls. Clients who were prepared to take a medium amount of risk and were invested in medium risk funds in 2020 lost c.15% of their money in the late February to late March Coronavirus-driven market fall, although they recovered a significant part of those losses over the next few months if they had held on. Allied to this point, if volatility has risen sharply, probably as a result of sharp market falls, the fund manager may have to sell some assets that have fallen to keep the fund’s volatility rating within the ESMA band. This could result in some losses being ‘locked-in’ if markets recover relatively quickly, resulting in the fund’s recovery taking longer. But hindsight is a tough taskmaster – it would be difficult for the fund manager if the risk rating is an important marketing feature and s/he had not acted while markets kept falling.
Nevertheless, ESMA is a reasonable, practical and easily understood method to reflect an investor’s risk/reward profile. At Cantor Fitzgerald, we take a lot of time to understand a client’s risk profile and to ensure our portfolios reflect it. In fact, as many of you know, we update clients’ risk profiles regularly and make sure the portfolios remain correctly aligned.
So, you may find it surprising that a number of risk-rated funds on the Irish market state that their risk ratings can change over time. It is understandable that the rating could change in a sudden market move but you might have thought the fund managers would be required to re-orientate the portfolio to bring it back to its ESMA rating over a reasonable time period.
In fact, I have come across a fund that was initially sold as a Risk 4 fund (it actually still has ‘4’ in its name) but is currently assessed as a Risk 5 Fund. Its risk rating may well have changed during the Coronavirus market fall in March 2020 but the fund manager has not, or has not been obliged, to bring it back to a ‘4’ rating. The Fund has, with hindsight, done quite well as it has a relatively high weighting to risk assets, and so I guess that investors in the fund are quite happy.
But, if they had invested in it a few years ago when the Risk rating was 4, and chosen it because of its ‘4’ rating, are they aware they now have a ‘5’ rated fund? And do buyers of the Fund today know it is a ‘5’ rated fund given there is a ‘4’ in its name. This means the Fund has a higher risk rating than implied and that is likely to fall more than ‘expected’ in a market correction. The fund’s current description on its website actually states that it targets ‘a volatility range of 5% to 10% over a rolling 5-year period’ which is an ESMA 4 rating, but then further down the webpage states that it has a risk rating of 5.
Perhaps not surprisingly the fund manager’s multi asset funds in this range that have a ‘2’ and a ‘3’ in their fund names are currently risk-rated as a ‘3’ and a ‘4’ respectively.
Who is responsible to inform the investor? The fund manager? The financial adviser? Or is it up to the investor to keep themselves informed?
And if it is an ARF investment, upon which the quality of retirement living of the investor could well be heavily dependent, the investor could unknowingly be exposed to a higher risk profile than they should have, at a time in life when the timeline for recovery in asset values is much shorter. Again, whose responsibility is this?
Bottom line: monitor your investments regularly, and if a fund/portfolio you hold has done significantly better than you would have expected, of course be happy about it but do check the risks taken and currently being taken.
As I wrote at the start of this article, ‘risk doesn’t matter…until it does.’
Pramit Ghose is Global Strategist with Cantor Fitzgerald Ireland.
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