Are model portfolios still on point? (Long read)
By Holly Black
Evidence mounts model portfolio risk ratings may not be reliable
A lack of clarity about how model portfolios are risk rated could mean advisers and clients end up choosing inappropriate investments.
Research seen by Money Marketing shows a significant disparity in ratings on products with the same label.
Analysis of more than 500 model portfolios carried out by risk profiling service Dynamic Planner exposes how different the asset allocation and strategies of portfolios with the same description can be. It reviewed some 540 model portfolios used by advisers, comparing their labelling and stated risk rating.
Among growth portfolios the median risk score was six, but the risk ratings for the group varied from two right up to 10 at the top of the scale; a significant variance for a group of investment portfolios with the same overall objective.
Income portfolios vary from a maxi-mum profile of seven to a minimum of two around their median of five.
Dynamic Planner proposition director Chris Jones says: “There is this anomaly where the name of a fund or portfolio doesn’t have anything to do with its risk level. When you see it in black and white, you realise how striking this disparity can be.”
The major concern in this is that advisers and their clients could end up investing in unsuitable portfolios because they have been labelled in a way that does not reflect their underlying asset allocation.
Of the portfolios analysed that had a risk rating of two, the maximum allocation to emerging markets equities was just 1 per cent. Meanwhile, portfolios rated a 10 on the risk spectrum had up to 62 per cent of their assets in emerging markets equities.
Portfolios rated a two typically had 52.8 per cent of their assets in cash, while no portfolios with a 10 rating held any cash. It means the strategies and therefore outcomes of growth portfolios, which may have a risk profile of anything from two to 10, are entirely different.
This significant variation in risk profile is not just evident in growth and income portfolios either. The risk ratings on balanced portfolios ranged from three to six on the Dynamic Planner risk scale.
Defaqto insight consultant Fraser Donaldson says: “I don’t think this vagueness is anything new. If you compare cautious portfolios A and B, they can be wildly different.”
FCA moots action
A key issue is that while risk metrics have evolved, they still have many subjective elements. One investor’s balanced may be another person’s aggressive, and the danger of trying to firm up the definitions too much is that they become excessively narrow.
Back in 2011, for example, the Investment Association decided to remove the active, cautious and balanced managed fund sectors and replace them with the 0-35 per cent, 20-60 per cent and 40-85 per cent shares sectors. But a portfolio with 40 per cent equities can still perform very differently to one with 85 per cent of its assets in the stock market.
Karen Barwick, director, Laurus Associates
The underlying difficulty with risk is that everybody’s perception is different – every adviser’s will be different and every client’s will be. Without everybody using the same thing I don’t know whether you would be able to squeeze out those variations. Model portfolios are full of jargon to the client. Does it really mean much to them? You are not going to get clarity on model portfolios; I can’t see fund managers wanting to fall in line, so it becomes the job of the adviser to say that this is on the surface balanced, but if you really break it down, how much is overseas, how much is property and all the rest? It does put the onus on us if there is a claim. If you were to be planning on each of those assets individually, would you do it?
Informed Choice financial planner Martin Bamford says: “Labelling has improved in recent years and the Investment Association has done a lot of work in this area, but looking under the bonnet of any investment is essential. You should never take a product at face value.”
Donaldson adds: “Risk rating is not a precise science but it’s a good guide and probably a better one than a portfolio giving an overview of its strategy or saying it will have somewhere between 40 and 85 per cent of its assets in equities.”
Labelling of model portfolios in particular is certainly an issue the regulator seems concerned about. In its platform market study, released last month, the FCA said: “The risks and expected returns of model portfolios with similar risk labels are unclear.” It warns that consumers using these portfolios may have the wrong idea about the risk-return levels they are taking on.
That’s a growing concern at a time when more advisers are turning to model portfolios to minimise the time cost of investment selection. The FCA estimates the amount invested in in-house model portfolios soared from £5bn in 2011 to £38bn last year. Growth has been fastest on adviser platforms – with assets invested in model portfolios growing by up to 25 times over that period.
"There is this anomaly where the name of a fund or portfolio doesn’t have anything to do with its risk level. When you see it in black and white, you realise how striking this disparity can be"
The regulator is confident model portfolios labelled similarly are exposing investors to very different underlying assets and volatility in returns. In its analysis it found inconsistency in the level of risk within models when assessed by their underlying asset allocation across all naming conventions, particularly in medium- and high-risk offerings.
It found that the exposure to bonds in portfolios named moderate or balanced varied from less than 5 per cent to more than 60 per cent, for example, concluding: “Many portfolios labelled as medium risk could be categorised as high risk or low risk.”
The same was true when portfolios were compared by volatility. The regulator says “judging risk based on naming convention does not necessarily help consumers or advisers understand the degree of risk investors would be exposed to” and, at worst, such naming conventions could mislead investors into portfolios with a significantly different level of risk than they expect.
There is certainly an onus on product manufacturers to ensure that their objectives are explicit and their labels relevant. The regulator is mooting the introduction of disclosure requirements on model portfolios but currently there is no standardised way for them to display information about their risk level or strategy.
Donaldson says: “In terms of aims, objectives and stated strategies, portfolios – like funds – vary widely. Some are very broad and others are more precise. It varies from almost nothing to almost saying too much. That means it’s down to the adviser to do due diligence; don’t simply accept it’s cautious because that’s how it’s labelled.”
Turning the tables
Jones thinks there is another issue at play here, too. A near-decade-long bull market means risk has slipped down investors’ priority lists. Many newcomers to the stock market will only ever have known a risk-on environment where shares and markets seem to rise regardless of the economic environment or macro news.
He says: “There’s an issue in that people tend to judge a fund by the returns it has delivered and not the risk it has taken to achieve them.”
But risk is starting to come back on investors’ radars as a number of macro issues cause uncertainty around the globe. Perhaps concerns around trade wars and Brexit, among others, will get people thinking more about their portfolios from a risk-reward perspective rather than purely focusing on maximum growth.
Jones adds: “It’s important to understand how a fund is run and look under the bonnet. Advisers and clients need to consider what a portfolio is designed to do and how important managing risk is within its aims.”
"One person’s cautious is another’s adventurous, so it’s important to look under the bonnet at what is really being held and ask yourself if that fits with the client’s objectives"
That due diligence is at the heart of the adviser’s role in selecting model portfolios. As long as advisers correctly risk-profile their clients and do their homework on the portfolios they are using, then they should be able to reach the appropriate solutions for the investor.
Discus director Gillian Hepburn says: “For advisers, the key is doing the right due diligence and not just relying on the labels put on a product. They need to be sure they understand the underlying asset allocation.”
She adds: “I think the fact growth portfolios range from two to 10 on the risk scale isn’t that surprising. Different portfolios will be aiming for different levels of growth. The important thing is how much growth you achieve for the risk you are taking.”
But while there is this uncertainty about whether a model portfolio does do exactly what it says on the tin, some advisers are avoiding them.
Wingate Financial Planning director Alistair Cunningham says: “One of the reasons we don’t use outsourced portfolios is because of the lack of control and inability to map the portfolio to our own risk questionnaires and the outcomes we expect.
“Ultimately, it is the adviser’s job to asses an individual’s ability to take investment risk and how well they can withstand any losses. But even the advisers’ assumptions will differ.”
Equilibrium partner Mike Deverell adds: “We don’t use external model portfolios. It’s a minefield; one person’s cautious is another’s adventurous. I think it’s important not to rely on labels or risk ratings and actually look under the bonnet at what is really being held. Then ask yourself if that fits with the client’s objectives.”
There is a sense that things are already improving and that product manufacturers as well as the regulator and IA are starting to take labelling more seriously.
The FCA says it will review the situation and potential measures it may take in the future could include introducing disclosure requirements similar to those that apply to funds or requiring firms to use standard terminology to describe their strategy and asset allocation.
In the meantime, it’s going to be up to advisers to do their homework.
Bamford says: “I disagree with the labelling of portfolios on a regular basis and we often find that people are taking more risk than is necessary for the returns they are achieving. Funds and portfolios are getting better and they can get scrutinised and badged by a third party, but at the end of the day it’s subjective and what one adviser or client thinks is cautious, you might not.”
Looking at model portfolios in a new light
The regulator’s platform report shows it is accelerating its focus on helping investors assess value for money. It defines that as the return an investor gets for the level of risk they take, after charges.
As a result, the FCA is considering putting model portfolios into the same regime that is already applied to multi-asset funds, with each portfolio required to declare a risk-based benchmark as part of its objective.
The review points to the rapid, 25-fold growth in risk target managed funds over the past six years as a key indicator of the need for greater clarity in this part of the market. These funds are built, to coin the old Ronseal tagline, to do “exactly what it says on the tin”.
"Many portfolios use labels like balanced or cautious, which don’t actually reflect their underlying risk"
Unfortunately, the FCA’s analysis, which was based on Dynamic Planner’s asset allocation model, shows that many portfolios don’t pass this test and instead use labels such as balanced or cautious, which don’t actually reflect their underlying risk.
The report is good news for advisers. Six months from now, firms will be in the middle of their first annual reviews post Mifid II.
Demonstrating value to clients by helping them understand the performance of their portfolio in relation to a benchmark, which reflects the risk the client agreed they are willing and able to take to achieve their objectives, is much more powerful and reassuring than relaying the absolute change in value, particularly if the portfolio itself is explicitly managed within the risk profile to deliver, or indeed beat, the benchmark after charges.
Ben Goss is chief executive at Dynamic Planner