We are now a year on from the crash and volatility of spring 2020 and, while the country takes tentative steps out of lockdown, risk remains top of mind for many investors and their advisers.
I have no doubt the fluctuations of the last 15 months are also on the mind of the Financial Conduct Authority as it works on the postponed Assessing Suitability Review 2, which has a published objective of focusing on the advice consumers receive around retirement income. The pandemic will have provided even more pause for thought. As in any stockmarket crisis, it is older retail investors with less time to recover any losses who potentially have the most to lose.
It is also that it is the older generations who have more to invest and any crisis of confidence among this group could have significant consequences. Across the UK and Europe, governments and asset managers need functioning investment markets and engaged retail investors to support their post-pandemic rebuilding programmes.
Risk/reward indicators
Risk is also on EU regulators’ minds too, with a recent decision to try and end the Ucits exemption and potentially apply the PRIIPs KID and Summary Risk Indicator (SRI) from 1 January 2022, subject to EU Parliament and Council approval – albeit this is still being debated.
This is neither the time nor the place to discuss the differences between Ucits’ Synthetic Risk Reward Indicator (SRRI) and PRIIPs’ SRI. What is the case, however, is that many funds in the last year – at one point more than 40% of UK Ucits according to FE FundInfo – have had to change their risk indicator over the last year because their risk levels changed. The investor was led to believe they were investing in a fund with one risk/return characteristic but in fact, when risk manifested itself, it turned out sometimes they were investing in something else entirely.
This actually takes some doing when you consider that, for either scheme, the risk expectations are so broad it is like trying to comb your hair with a garden rake. As a comparison, the potential outcomes for risk levels 3 or 4, the two most commonly used categories, cover seven different risk profiles in Dynamic Planner.
Historical performance
The situation for the adviser and investor – and ultimately the manager – if complaints ensue is made considerably worse by the fact that the risk indicators project forward based on historical performance, which meant the period of relatively low market volatility up to the beginning of 2020 was reflected in lower risk indicator scores, right at the top of the market.
Only once the volatility of a fund has broken its category boundaries for 16 weeks in a row does the manager need to change the label for an SRRI. So when you look at the actual performance of funds in SRRI 3 for example, the investor could have experienced an annualised volatility of anything from 1.5% up to 17.5% over the last 12 months. Clearly it is very difficult to manage expectations, let alone build an accurate financial plan, around ranges this wide.
While these high-level regulatory risk labels are helpful in that they classify broadly different categories of investment product – for example, leveraged versus non-leveraged products – labels based on past performance can be no indicator at all.
As investors and their advisers increasingly rely on risk-based plans for retirement, the need for more and more accurate planning and a tighter relationship between manager, adviser and client grows. Consider a client with a pot of £250,000 at retirement. They would be looking at accepting a value at risk of £22,000 or £46,000 if they choose between risk profiles 3 and 7 at 95% in Dynamic Planner. Clearly this is a material difference and yet these profiles sit within a single SRI category.
Continually evolving view
To assess risk successfully, you have to look forwards and maintain a continually evolving view of asset class risk – the principal determinant of the variation in returns – using a covariance matrix which takes a view on asset class correlations.
To manage risk in decumulation, it is vital not only that the investor is advised accurately around their needs and capacity to take on risk, but that investments are actually managed to that risk every month – not on a quarterly, let alone an annual basis. When an investment manager only reports it has exceeded volatility limits 16 weeks after the fact, then if the client is continually withdrawing income in a falling market, the damage has already been done.
Risk-managed decumulation requires even tighter targeting around forward-looking expectations. Looking at the universe of risk-managed decumulation funds targeted against Dynamic Planner’s risk profile 4, for example, during 2020 only one fund strayed out of its monthly value at risk expectation, and then for only one month.
Fortunately, risk targeting in both accumulation and decumulation is becoming far more prevalent, with managers supporting advice firms who design their propositions on a series of tightly managed, forward-looking risk profiles. The result is that investors and advisers have much clearer expectations and can plan accordingly.
Ben Goss is CEO of Dynamic Planner
