Typical assessments of risk are based on the likelihood of an investment under- and out-performing the average. But a totally different picture of risk emerges when it is based solely on your chances of losing money.
September 11, 2010
By Bruce Cameron
If you think that because you are invested in a property unit trust fund your investment has less risk than if you were in an equity fund, think again.
If you think that by investing in a higher-risk equity unit trust fund you can automatically expect better returns over the longer term, think again.
If you think that the way to assess risk is by compartmentalising the investment risk of unit trust funds by generic sectors, with money market funds at the bottom of the scale and resources and basic industries at the top, think again.
Research by PlexCrown Fund Ratings, which is part of the Plexus financial services group, has found that many investors and their|advisers are blissfully unaware of the risks they are actually taking because of the way risk is traditionally measured and classified.
The PlexCrown research shows that much of the conventional|wisdom on market risk is not very wise, because the wrong assessments of risk are used. For example, many financial advisers place investors in property investments, totally unaware that the risk of under-performance is extremely high - it can be higher than that of many equity investments.
How much can you lose?
Ryk de Klerk, a director of PlexCrown Fund Ratings, which developed the PlexCrown risk rating methodology, says that most investors want to know what their chances are of losing money, and this is not what most ratings of investment risk measure.
When the risk of a unit trust fund is assessed solely on under-|performance, an entirely different risk pattern emerges from that provided by measuring risk based on both under-performance and out-|performance, De Klerk says.
PlexCrown Fund Ratings has based its research on restricting its measurement of risk to the propensity of a unit trust fund or sector to under-perform the average.
De Klerk says investment risk measurements based on overall risk test the propensity of a fund to under-perform and out-perform over a given period.
So, if over a 10-year period, Fund A swings by a maximum of 10 percent above and below the average market return (a range of 20 percent), it is considered more risky than Fund B, which swings by a maximum of five percent either way. The more volatile a fund is in terms of this measure, the more risky the fund is assumed to be.
But this approach is wrong, De Klerk says. In effect, the overall risk of a fund is being clouded by upside risk, with unit trust funds that maintain a variation above the average performance being punished in the risk measurements.
Investors should be more concerned about downside risk than the potentially higher returns they can expect by taking on additional risk, De Klerk says.
Key findings of the PlexCrown research include:
# You should be hesitant to use generalised tables of market sector risk. The traditional tables are not accurate, because risk is dynamic and because of the vast variation in risk among funds within a sector.
Funds use the Association for Savings & Investment SA compartmentalised risk table to claim a risk profile that can be totally incorrect and misleading. Your risk of losing money may differ vastly between funds in the same sector or the sector average.
# A top-performing general equity unit trust fund, such those managed by Allan Gray or Oasis, take a lot less risk than under-performing Stanlib or Metropolitan funds, which apparently take on more market risk.
# The presumed higher risk of a top-performing domestic asset allocation prudential variable equity unit trust, such as the Symmetry Balanced Fund of Funds, could in fact have the same risk as an under-performing bond fund.
# The more a fund under-performs, the more likely it is to have taken on higher risk. In other words, it will be making big bets in the market. This can result in sudden stellar performance, as happened to Stanlib three years ago, when it was the top-performing domestic unit trust management company for 2007. But Stanlib dropped to near the bottom as the big bets went wrong.
# A fund that takes high risks is far more likely to under-perform than out-perform on the basis of risk-adjusted returns.
According to De Klerk, the downside risk of 78 percent of domestic equity general funds with a history of seven years or more that out-performed the sector average in the June 2010 PlexCrown survey was lower than the average.
He says the worst thing you can do is rely on generalised risk.
"The managers of lower-risk funds tend to focus on long-term earnings growth potential and valuations rather than the market in general. It is this very strategy that allows them to reduce the damage in portfolios when a bear market is entered and equity prices slump," De Klerk says.
You have a right to know
Investors and their advisers need to be fully informed by collective investment scheme (unit trust) management companies of the risks taken by fund managers, De Klerk says.
Investors should be "adequately and continuously" informed of the risks of individual funds, the relative risks of the major asset classes and the shifts in risk over time, he says.
"It is essential that all stakeholders, especially investors and investment advisers, be made aware of the significantly diverse risk attributes of funds despite their being classed in the same generic risk category," De Klerk says.
Where a fund has a performance history of less than seven years, it should be given the average risk rating of the sub-category in which it falls until the fund qualifies for its own risk rating after seven years.
De Klerk says that information about risk ratings should be readily and freely available to anyone at any time on:
# The website of the Association for Savings & Investment SA;
# Fund fact sheets and marketing material; and
# Data providers' performance tables published in the media.
The information should be updated regularly and should be taken into consideration in risk-profiled investment planning.
He says the risk ratings should not be restricted to the PlexCrown risk rating methodology but should include other assessments of risk.
Note: PlexCrown's downside risk rating tables are available free of charge at www.plexcrown.com
Plexcrown risk rating system
The PlexCrown risk rating methodology is based on smoothed rolling monthly periods over seven years. Account is taken of the return on cash as a hurdle rate (or minimum acceptable return) compared with the average downside risk of equally weighted funds in the main Association for Savings & Investment SA collective investment scheme unit trust categories.
The downside risks of individual funds are then plotted on a bell curve within 10 intervals of the standard deviations from the average. This risk categorisation implies that funds or sectors with a risk rating of one hold the lowest risk, while those with a rating of 10 hold the highest risk.
The downside risk of money market funds is theoretically zero, but PlexCrown Fund Ratings believes that credit risk is a potential issue in the calculation of possible downside risk, so a risk rating of one is allotted to all money market funds.
De Klerk says the downside risk of the market sectors and asset classes has been influenced by various factors, including the evolution of global business and new industries, domestic developments - such as the abolition of the financial rand and black economic empowerment - new asset classes and unit trust sub-categories, the addition of new funds to the sub-categories and the re-classification of sub-categories.
From Personal Finance published on September 11, 2010
