Caution needed over ‘Cautious’ funds
Barclays’ £7.7m FSA fine is a punishment for weaknesses in its sales process. I expect these had more to do with the way it frames questions about risk tolerance and interprets the answers than to do with its assessment of risk in the products it then matches customers to. But it is still striking that at least one of the two funds at the centre of the customer complaints is one that has regularly sat well inside the returns range of the lower-risk IMA sector called Cautious Managed. Striking, but not surprising.
The peculiar feature of packaged products created at the low end of the risk spectrum is that the downside risk relative to cash is actually much harder to estimate accurately than in equity funds, yet has far greater impact. However ‘cautious’, there is an unavoidable quantum change between cash and low-risk product structures. That is a big issue when cash returns are really unsatisfactory, as now, but customers’ composure when taking risk is low.
Managing the quantum change safely, so that advisers can be sure customers will have sufficient composure to weather disappointments relative to risk free savings, may require even more education and explanation than the same discussions about location on the risk spectrum higher up, where it is all about different levels of exposure to equity risks.
Banks have proved particularly unable to manage this process but the problem is not confined to banks. A pattern over the past two years reported by Cofunds is that advisers have dramatically increased their allocations to Cautious Managed funds, particularly multi-manager funds, to the point where they account for almost a third of net flows on the platform. Some of this is at the expense of Absolute Return funds, which had posed problems for risk assessment even before the FSA expressed reservations about this label, and they typically hold less in equities.
Measuring the distribution of past returns within the Cautious Managed category (using Lipper data), and trimming the top and bottom deciles to try to avoid capturing atypical and miscategorised funds, we find a fairly stable range from top and bottom of about 7% per annum, both before 2008 and after 2009. Relative to cash, this is actually inconveniently wide. But it is perfectly natural once you move from cash to a wide range of instruments by duration and credit risk and a wide range of (albeit small) equity exposures.
At this end of the risk spectrum many of the incremental return sources take on the nature of insurance, gathering premium income for bearing the risk of occasional losses. So there will always be some exposure to a low probability but high impact event such as the explosion of the distribution in cautious managed fund returns from 7% to 20% in 2008, after the banking crisis.
For most investors, the answer is to split exposures between genuine risk free assets and equities: bets on or off the table but nothing in between. If inflation is an issue for their risk free assets, they will normally be able to protect against both capital market and inflation risks by holding index linked National Savings certificates or index linked gilts. Both are also more tax-efficient than low-risk packaged products.
The industry discourages this ‘portfolio separation’ because it finds it difficult to attach a fee to the risk free portion. There is therefore a strong financial incentive for manufacturers to keep creating ‘low-risk’ products and advisers (whether taking commission or, after RDR, charging asset-based fees) to keep allocating to them. I do not believe the FSA has quite grasped the nature of this problem.
This piece was also published by Money Marketing.