We mentioned in our last piece how, in everyday life, many people think of "risk" in predominantly negative terms; something to be avoided or a threat that we hope won't materialize. In investment, however, risk is inseparable from returns and, rather than being desirable or undesirable, is simply unavoidable.
There are many aspects of risk which a fund manager has to deal with on a day to day basis and the extent to which he can diversify away any of these will partly depend on the mandate of his fund. If it has a broad remit, for example a global, multi-asset or multi-manager fund, then he will be able to reduce risk by diversification of assets or by geography. On the other hand a country or sector specialist fund will have less scope to do this and will usually have a higher risk rating assigned to it by the asset management company or an independent ratings agency such as FE.
Market, or systematic, risk affects all securities in the same manner and results from factors that cannot be controlled by diversification. It could result from global economic events such as the financial crisis, terrorism, international conflicts leading to war, or acts of nature such as a tsunami. Passive funds track a benchmark and only incur market risk whereas active funds take on additional risks, which are carefully managed, in the hope of achieving superior returns. A fund manager will be highly qualified and experienced by the time he assumes control of a fund and it is these skills that investors in an active fund are paying to access. Alpha is a measurement of how much a fund manager has out-performed his benchmark index and is also known as ‘value added’.
Sources of risk which a fund manager will analyse carefully include economic, social, political and legislative changes which may impact the performance of his investments. For example, the introduction of the Government’s ‘Help to Buy’ scheme had a big impact on the housebuilding sector. Managers will also be watching with interest the UK referendum on staying in the EU and considering the implications for companies they hold. While the outcome of these macro events may not always be predictable, an astute fund manager will assess the positives and negatives and reposition his fund accordingly in the hope of generating alpha. Another difficult to predict form of risk is exchange rates which can affect companies’ ability to compete in overseas markets and impact profits on translation. The fund manager will monitor his exposure and may employ hedging strategies if appropriate. Liquidity risk refers to the prospect of not being able to buy or sell an investment when desired; it is most likely to affect smaller companies funds and those investing in certain overseas markets. The fund manager may deal with this by closing the fund when it reaches a size where trading becomes difficult.
A fund manager will primarily take an analytical approach to evaluating investment opportunities, considering many facets of risk, from global issues down to the business risk of each individual company. To diversify away some of these risks, he will ensure he has exposure to a range of companies across a range of industry sectors as not all will be trading well simultaneously. He may also diversify geographically by investing overseas or in companies with international sales if his home market is performing badly. However, there will also be a subjective element to aspects of his decision making when he uses his expertise and experience to assess such issues as quality of management and developing themes. Remember that fund managers are people like the rest of us and their styles will differ according to their own risk profile- some will be very cautious and others more adventurous. This is where our partners Square Mile add a great deal of value; they meet regularly with fund managers, getting to know their personalities and styles and ability to react to changing market conditions.
The level of risk a fund manager takes on will be closely measured and monitored by quantitative specialists to ensure it remains appropriate for the objectives of the fund. A range of methods are used to measure risk* but common ones include: standard deviation which measures volatility of a funds returns against it’s 3 year average, R-squared which shows how closely a fund is correlated to its benchmark, beta which shows sensitivity to market moves and the Sharpe ratio which reveals the extent to which returns are due to good investment decisions or derive from higher risk. Financial Express use standard deviation relative to the FTSE100 to determine risk ratings and these can be viewed when researching funds in the Willis Owen Fund Space service. However, while all these measures indicate the overall risk of the portfolio, they do not distinguish between different sources of risk such as industry or currency risk which the fund manager will also take into account when managing his fund. For instance, energy stocks are likely to be sensitive to oil prices, consumer companies to retail sales trends and banks to interest rate rises.
As a case study of an asset manager, Jupiter encourages fund mangers to seek out-performance through an active approach but simultaneously imposes risk controls. They have a risk management policy which encompasses three areas: all fund managers are made aware of the level of risk in their portfolios and work with Jupiter’s Independent Portfolio Analytics Team (PAT). Compliance and operational risk departments apply a set of portfolio-specific internal limits to the risk levels in each fund. The Head of Investment Risk, the Chief Investment Officer, the Risk Committee and ultimately the board discuss market risk levels with the relevant fund manager, who may then be asked to adjust his portfolio accordingly.
We can see that the issues which fund managers pay close attention to as part of their investment process overlap with the factors a private investor should also consider when selecting funds. These include: philosophy, objectives, asset allocation, financial analysis, risk evaluation and ongoing monitoring of holdings. The process should be rigorous in order to identify measure and price risk.
So, we have now looked at how fund managers deal with risk. However, this is a complex subject and each fund manager will deal with risk according to the rules their firm apply – I have only scratched the surface, but I hope that this has helped your understanding of risk. My next piece on risk will deal with how we can complement the fund manager’s approach by ensuring we construct a portfolio which is appropriate for our own attitude to risk.
*See our financial jargon section
for more detailed definitions.
Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.