Time to stop comparing apples with oranges

IA Mixed Investment peer groups provide an broadly understood metric for comparing multi-asset funds, however, do advisers realise that they're putting client suitability at risk?

The IA Mixed Investment 20-60% Shares sector is an excellent case in point. At the time of writing the top performing funds in this sector include yield-chasing distribution funds, ethical funds and a variety of cautiously-managed funds. An eclectic, mixed bag of funds to say the least, with the sector by definition holding from 20% to 60% in equities. How on earth can a fund with 20% in equities be compared to one with 60%?

 

When assessing multi-asset fund performance, its far too easy just to make a judgment call on the manager based solely on how a fund has done versus its benchmark. Unfortunately many investors still use this approach in selecting funds. Yet lets be frank, this just does not cut the mustard. There are simple reasons why this approach is fundamentally flawed. It is tantamount to comparing apples with oranges. For all intents and purposes, particularly in the short-term, these types of comparisons are meaningless.

 

So how do you ensure that your clients are suitably invested?

Meaningless peer group performance

Such a variety of different fund offerings, all doing different jobs, investments should never be compared on performance alone. Advisers need to ensure a given portfolio of investments is suitable for a client. Using peer-group performance in isolation may end up with a clients money being invested in an unsuitable fund.

[it's]...all about generating strong risk-adjusted returns, within a client’s risk profile

Mixed up incentives

The fund manager of a retail multi-asset fund invariably liaises with an intermediary rather than the end investor. This typically means there can be a disconnect between the fund manager and the requirements of the end investor. Financial advisers in this sense ensure the managers approach is right for their client. However, manager incentives may not be closely aligned with advisersneeds, suitability requirements or investor expectations.

 

For example, peer-group benchmarked fund managers have traditionally been incentivised to outperform their benchmark. However, if the evaluation period is over a short-term time horizon or the level of outperformance is closely correlated with manager remuneration, the fund manager might be incentivised to take more risk than the client actually wants. Taking more risk than necessary may render the fund unsuitable for end investors, which stores up potential future mis-selling risk for the adviser.

there can be a disconnect between the fund manager and the requirements of the end investor

For these peer-group benchmarked funds, poorly-aligned incentives are a real issue, as the objective is usually to outperform a pre-determined peer group such as the IA Mixed Investment sector rather than meet the right client outcome. The right outcome for a client could be to keep costs reasonable, to keep their investments within their risk tolerance and to have an outcome that is consistent with their original investment goals.

 

Benchmark hugging

 

A further problem facing peer-group benchmarked funds is that managers, in order to control risk relative to their respective sector will often not deviate too much from the asset allocation of their rivals.

 

For instance, a manager may be required to hold a certain allocation over or underweight in European equities relative to their peers. This could result in a situation where a fund manager has no option but to hold client capital in a particular equity market or bond, even if they believe the outlook for that investment is poor. Constraints of this nature are clearly unhelpful. They can distort a fund’s risk/return profile over time and have no benefits for customers, whose primary concern is usually to meet a defined outcome.

 

Avoiding nasty surprises

 

The most important thing for advisers is to ensure that their clients receive no nasty surprises. A client’s journey needs to be managed carefully to reach their defined outcome. This is achieved by assessing their attitude to risk and placing them in a portfolio that matches this. The objective then becomes all about generating strong risk-adjusted returns, within a client’s risk profile, rather than peer-group comparisons.

 

Ultimately, the main risk investors are interested in is the risk of losing money. Newer types of multi-asset funds, such as risk-targeted strategies that help investors understand how much money they could gain in the good times and what they could lose in extremes are therefore helpful for both advisers and the end investors. In this sense, multi-asset funds must seek above all to generate the best possible long-term return within their risk parameters, and not seek to ‘beat’ a peer group with diverse objectives.

 
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