“This is frequently the case where risk is measured using historic volatility, often with a short-term, five-year window. This is very backward looking. The risk of the portfolio is assessed by what has happened to it in the recent past; and very unstable – does that recent past include a crisis or not?
“Measuring the risk of a portfolio effectively should use long-term simulations of possible future values of the portfolio. And crucially, the risk of the portfolio needs to be consistent with what ‘risk’ means to the long-term investor.”
Too much tactical active management and too little diversification, such as focusing only on certain asset classes, sectors or geographies, can also make portfolios less suitable for investors, says Davies.
“This is because both can cause the portfolio to be a less constant and stable match for the requirements of the investor, and also place greater weight on the selection skill of the managers than on the risk profile of the client.”
How many risk profiles?
It is not unusual for a MPS provider to offer portfolios based on five different risk appetites, but some will cater to slightly more. So, is there a minimum number of risk profiles that advisers should seek from an MPS?
The obvious number would be the same as the number of risk profiles, which varies from five through to 10 depending on the advice service, says Storey at EV.
“However in reality, the lowest and highest of the risk profiles tend to be offered alternative solutions, such as cash for the very low risk.
“So MPS ranges will usually focus on the middle of the risk profiles. As a result, it’s usual to see a minimum of three MPSs for five risk categories, and around seven for advisers using 10 risk-profile categories.”
Where there is more than one MPS within a risk profile, Storey notes the importance of understanding how close to either a lower or higher category the MPS is, in order to match the client’s requirements.
Davies at Oxford Risk also says that while he would usually recommend best practice being to divide investors into seven risk profiles from ‘very low’ to ‘very high’, the two extreme categories would typically not have specific portfolio solutions, leaving them for the middle five.
“On the very high side, investors with really high tolerance or capacity to take risk should still seek a diversified portfolio, and not concentrate their portfolio only in just the highest risk assets.
“So they should largely invest in the most risky of the five central solutions, but have some extra space for a portfolio of risky speculative investments, done carefully, should they want it.”
Additionally, anything more granular than seven profiles would exceed reasonable ability to truly distinguish between two adjacent categories of either investors or investments, Davies says. “It’s just spurious precision.”
