Fund risk ratings may not be all they seem; The growing use of “risk-rated” funds by advisers and platforms could lead to investors being pushed into a product which does not match their risk appetite, experts have warned.

February 28, 2014 5:27 pm

Fund risk ratings may not be all they seem

By Emma Dunkley

The growing use of “risk-rated” funds by advisers and platforms could lead to investors being pushed into a product which does not match their risk appetite, experts have warned.

“Risk-rated” funds are typically given a number from one to 10, which represents a level of volatility that the underlying investment is expected to exhibit over time.

An increasing number of funds are being rated, partly because they make the process of selling appropriate products quicker and easier. But some think they are a potentially dangerous short-cut.

“A good adviser will have a long discussion with their client, but I’ve seen some people sent questionnaires in the post,” said Graham Bentley, managing director of investment marketing consultancy gbi2.

Another concern is that while funds are assigned a risk-rating number, they are not managed to this target and could therefore drift outside of the volatility range over time, leaving investors exposed to a greater degree of risk.

“These funds can fall outside a risk band,” said Mr Bentley. “They are given a rating, but it’s not the way the fund has to behave. “The shoehorning of a risk number to a portfolio is at best naive and at worst dangerous.”

Mr Bentley adds that investors’ circumstances may change over time and that their investment needs and risk appetite needs to be reviewed regularly.

The Financial Conduct Authority has in the past aired concerns over the sale process and questioned whether investors are being matched to the most suitable rated fund.

Rory Percival, technical specialist at the FCA, said last year that some advisers are not doing enough checks to see which risk band is the most suitable for their clients.

Rather than simply completing a questionnaire on their risk appetite, Mr Percival said investors need to be asked about their capacity for loss, their knowledge about investing and their time horizon.

One of the main providers of risk ratings, which fund groups pay for, is Distribution Technology. The firm risk-profiles 703 funds which together have more than £60bn in assets under management. Its ratings are reviewed on a quarterly basis.

There are also some concerns over how independent these ratings are, given that fund groups pay for the ratings just as bond issuers pay for credit ratings.

“The manager is paying the risk rating agency to rate their funds, so there will always be the possibility to influence the rating agency,” said Adrian Lowcock, senior investment manager at Hargreaves Lansdown.

“The issue for me is these products have not been designed for clients, but for advisers to be able meet their regulatory requirements and to sell to clients.”

More funds are attracting risk ratings, as they serve as a cost-effective way for advisers to meet due diligence requirements and help fund management groups with their marketing.

Ben Goss, chief executive officer of Distribution Technology, said: “We translate between the investor’s risk profile and the fund’s risk profile, to provide a consistent way of describing risk.”

Risk-targeted funds are another type, which differ as they are explicitly managed to stay within a risk band.

But risk-targeted funds are not ranked in categories within the Investment Management Association’s universe, making them tough for advisers and investors to find and compare with non-targeted funds.

Financial Express (FE), a fund data provider, plans to launch a group for risk-targeted funds, called Risk-Targeted Multi-Asset Solutions, within which there are five sectors to group the products.

These sectors will have 250 multi-asset funds, ranging from low to high risk. They will also be rated by FE, with a score based on their volatility. The ratings will not be paid for by fund groups.

FE said it has designed the new sectors to help advisers and investors select multi-asset funds that fit within their ability to tolerate risk.