Risk Targeted Funds - What We Consider Good Practice

Since the stockmarket falls suffered during the 2008 financial crisis, investors have tended to be more focused on their investment journey and therefore less concerned about how their investment is behaving on a relative basis. This can be partly explained by a reduction in risk appetite, following heavier losses than some had been expecting, and the desire to maintain a level of flexibility in line with their lifestyle. The rise of risk targeted funds since the crisis, illustrates this phenomenon although other drivers, including regulatory change, have also assisted their popularity. Square Mile acknowledges that the risk targeted approach is different from that of traditional managed funds and this is why we have dedicated a separate area to it within our Academy of Funds website. Whilst we do not see this approach by any means as a silver bullet, we believe there is much to commend over traditional managed funds. A key difference between risk targeted and traditional managed funds is the starting point. As the name implies, risk targeted funds target a specified level of risk and are structured around a perceived optimal asset allocation where theoretically, according to modern portfolio theory, investors can gain the highest level of return for the given level of risk. Traditional managed funds are less sophisticated in construction and give little regard for the efficient frontier, for example having an arbitrary 60% equity and 40% bond benchmark. We acknowledge that both approaches have their merits, however for investors who are focused on controlling their overall level of risk exposure, then the risk targeted approach is likely to be a more suitable option. Below we have listed 10 features which we see as good practice among risk targeted funds.

• Providing clear and tangible outcomes for investors.

• Having a means by which the manager’s skill and ability to add value can be measured.

• A strong understanding of the assumptions which drive a funds longer term strategic asset allocation.

• Validation of this asset allocation with a qualitative and pragmatic approach.

• Ensuring any assumptions remain appropriate and relevant through active engagement and regular reviews.

• Continual awareness and monitoring of the level of risk which funds are exposed to, including full portfolio look through on a timely basis.

• Seeking independent validation of fund risk levels.

• Dynamic asset allocation driven by risk and not asset class boundaries.

• Awareness of how investment vehicles are likely to behave compared to the index/asset class on which they are modeled.

• Regular reporting on portfolio activity so investors can understand what changes have occurred and the rationale for this.