How risk-targeted and risk-rated funds differ

What you’ll learn:

• What multi-asset funds are.
• How risk-rated and risk-targeted funds work.
• What are the pros and cons of each?

We take a look at how risk-rated and risk-targeted funds work, explain how they differ and look at the main pros and cons of each.

But always bear in mind the golden rule when it comes to investing – the higher the potential return, the greater the risks involved and the greater chance there is of you losing money.

No matter what level of risk you take, the value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

Broadly speaking, risk-rated and risk-targeted funds aim to give investors a firm idea of what they’re trying to achieve or the level of risk they’re aiming to take.

However the similarity of their respective names has managed to cause some confusion among investors – and while they may sound very similar, the way they work is anything but.

Both risk-rated and risk-targeted funds are types of multi-asset funds which, as the names suggest, invest in a variety of asset classes. While some funds, for example may invest in only shares or only bonds, a multi-asset fund will typically hold both of these, as well as property, cash and potentially even alternative assets such as commodities.

The main benefit of investing in a fund, multi-asset or otherwise, is that you hand responsibility for how your money is invested and diversified to a fund manager, who you then rely on to make investment decisions on your behalf. By investing in these one-stop-shop funds, you can effectively spread your risk. In theory, the performance of the strongest assets should offset the performance of the weakest, leading to steadier overall returns.

What are risk-rated funds?

A risk-rated fund is a fund that has been assessed by an independent risk-profiling firm, in a bid to determine how risky it is. A profiler assigns the fund with a rating, normally between one and 10, with a rating of one being the least risky and 10 being the most risky. A fund that has the majority of its assets in shares, for example, will have a higher rating than say, a fund that has more supposedly ‘safer’ assets such as bonds.

As an investor it’s then up to you to pick a fund with a rating that matches your appetite for risk. For example, if you have a medium or balanced attitude to risk, you might select a fund with a ‘five’ rating, whereas if you’re more cautious, you may prefer to go for a fund with a ‘one’ or ‘two’ rating. If you’re unsure about investing and what your risk appetite actually is, seek independent financial advice.

Find out more about what your attitude to risk might be

A risk-rated fund can have a number of goals, for example, its main aim could be to beat a particular benchmark or deliver a certain level of income. But importantly, the rating of any given fund is based on its make-up at the time of the assessment. Managers of risk-rated funds are typically not required to ensure that risk is held within a certain range and as markets change, so a fund’s risk profile could alter and become more or less risky as time goes on. In other words, investors need to ensure their chosen fund continues to match their needs and investment objectives.

What are risk-targeted funds?

The mandate of a risk-targeted fund is very different to that of a risk-rated fund – as the name suggests, risk-targeted funds target an explicit level of risk. Their main aim is to control the level of risk investors are exposed to over the long term. As such, a fund will be constructed with the goal of delivering risk-adjusted returns – it will take on a more specific amount of risk to deliver a particular level of return, to investors.

The manager will adjust the fund’s profile in a bid to ensure that the level of risk, or volatility, it’s exposed to remains within its set target range. While investors can of course still lose money, they’ll at least know that the fund manager must always remain within a guideline risk range – they can’t take on more or less risk to the portfolio.

Which is right for you?

It may be the case that neither style is right for your needs, so if you’re not sure, seek professional financial advice. But if risk-rated and/or risk-targeted funds do pique your interest, there are a number of factors you need to consider before investing.

First, a risk-rated fund will only give you an idea about what level of risk a particular fund will take. Risk-rated funds have sometimes been labelled as backward looking while risk-targeted are viewed as forward looking. After all, given that the market can change all the time, a fund rated five today, could be a four or six in a couple of years down the line. As such, you could end-up being invested in a fund that no longer meets your risk criteria. Second, risk ratings aren’t standardised across the industry, which means two separate funds with a highly similar make-up could have different risk-ratings.

Many experts also argue that the core objective of a risk-rated fund is to deliver investor returns and that keeping a watch on the fund’s level of risk is a secondary priority. However others suggest that because the primary consideration of targeted-return funds is to ensure they stay within certain risk parameters, this restriction can obstruct outperformance and maximising investor returns.

How to identify risk-rated and risk-targeted funds

Risk ratings on multi-asset portfolios are becoming far more commonplace and any fund factsheet or Key Investor Information Document (KIID) should clearly state whether or not a fund has a risk rating, and if it does, what that rating is.

The same applies to risk-targeted funds. But in November 2016, fund management trade body, The Investment Association, will be launching a new sector, entitled Volatility Managed, in which risk-targeted funds will sit, allowing investor to easily identify these funds.

It’s vital to bear in mind that no matter what steps you take to manage risk, your investments can still fall in value and you may get back less than you invest.

Find out more about understanding risk and return

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The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances.