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When risk and return don’t align

Fund managers display a high level of inconsistency across the risk spectrum.

There is a graph that almost every fund manager likes to use in their marketing material. It is an illustration of how their suite of funds compares in terms of risk and return.

The graph always shows a neat curve with their funds neatly spaced at regular intervals. It looks something like this:

Source: AVIVA

At the bottom left (RR1) is usually an income fund that offers stable returns with low risk of capital loss. The graph then progresses through multi-asset low-equity, multi-asset medium-equity, multi-asset high-equity and finally to a pure equity fund (RR5), which has the highest return potential, but also carries the greatest chance of short-term capital losses.

It is an illustration of something that makes perfectly good sense. The higher an investor goes up the risk curve, the greater the return should be.

“As an investor you have an expectation,” explains Brandon Zietsman, the CEO of Portfoliometrix. “No one takes on risk for no good reason. You would not take on more uncertainty unless you had cause to, which is that you’ll get more out of it.”

The way that this graph is presented in marketing material always makes this appear like it happens as a matter of course. It also portrays this trade-off as happening in a regular pattern.

In truth, however, very few managers actually get this right.

“There is actually a high level of inconsistency,” says Zietsman. “Asset managers are poor globally at producing a consistent set of results across the risk spectrum. The achieved results very seldom look like what’s on the brochure.”

Analysis by Portfoliometrix into the performance of funds run by a number of local managers over the last five years bears this out. The dots on the graph very rarely line up.

The analysis compares annualised returns against annualised standard deviation, or volatility. While this is problematic as a single measure of risk, it is nevertheless a useful proxy.

What the analysis reveals is that spacing and relation between funds of a single manager are very often mixed. There are also a number of examples of lower risk funds delivering higher returns than those with higher risk profiles.

In the case of one large manager, all five funds analysed across the risk spectrum produced more or less the same return. In other words, there was no benefit to investors for taking more risk. The firm’s equity fund actually delivered lower returns over the five year period than its multi-asset low-equity offering, but with nearly double the volatility.

The question is what investors should be taking from this.

Firstly, it’s obvious that any marketing material should not simply be taken at face value. What fund managers like to imagine they are doing and what they are actually achieving may not line up.

That’s why investors should scrutinise whether the risk they are accepting in any fund is actually being rewarded, and rewarded adequately. To a large extent this is already taking place amongst the large number of investors who appreciate that they are able to get equity-type returns from balanced funds that offer far better risk management.

However, it is just as important further down the risk curve. If higher risk funds are underperforming or only marginally outperforming those of lower risk, then what purpose are they really serving?

Secondly, it also suggests that one fund manager is not always good at doing everything. A firm running a very good multi-asset low-equity fund might not necessarily also be that successful at managing a high equity fund.

There could be any number of reasons for this, from the skill of the individual portfolio managers to asset allocation models that work in one environment but not another. What is important for investors, however, is that they appreciate that having all their investments with one manager may not be the best approach.

This also highlights the value in multi-managers that specialise in asset allocation and selecting specific managers to look after different parts of the portfolio. Over the last few years some multi-asset fund of funds have done exceptionally well, specifically through being able to offer better risk management than single managers.

Investors need to be alive to this, and appreciate that in the unit trust world higher risk does not always mean higher reward. Quite often, the opposite may be true.

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Thats just because the equity markets have been flat (the risk, market volatility), over the past 2 years and especially in 2016.

Back in 2013 the 10x high equity fund (if the unit trust had existed back then) would have grown 20.37% and in 2014 it would have given 12.18%, no low equity or stable fund would have done.

One would not be able to guess with any accuracy where an all or high equity fund will be 5 years from now, but I bet one could guess quite accurately where a low equity or especially a stable fund will be.

Now you know what type of adviser Portfoliometrix are targeting…the adviser that doesn’t see the convenient timeline chosen to make the point, the adviser that thinks that manager selection adds real value, and the adviser that doesn’t understand the impact of the additional layer of fees from multi management. Poor article…

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