Page 107 - Profile's Unit Trusts and Collective Investments 2021 issue 2

Investment Risk

Risk Profiles of Funds
In order to choose appropriate investments, investors need to evaluate their financial
circumstances, their financial goals, their risk capacity and their risk appetite. All investors want
the highest possible returns for a given or acceptable level of risk, but not all investors see risk the
same way. It is therefore important to define each investor’s risk profile, both in terms of risk
capacity and risk appetite.
The collective investment schemes industry tends to simplify risk profiles into three main
categories: aggressive, balanced (or moderate), and conservative. (Sometimes this is fleshed out
slightly into a five-point scale which includes moderately-aggressive and moderately-conservative.)
These categories are usually not defined or quantified by the managers and intermediaries that use
them, save for the assumption that everyone understands intuitively that "moderate" implies greater
risk than "conservative," and so on. But the exact characteristics and precise dividing lines of risk
categories are seldom addressed.
Most investors probably don’t need much help in identifying their investment comfort zone.
Profiles are matched with a range of possible investments, ranging from conservative portfolios to
aggressive portfolios. This strategy also suggests that as investors become more averse to risk
(usually as they get older), they should seek to diversify their investments with regard to sector,
asset allocation, region, currency, the business cycle, and so on.
A problem with risk profiling is that it doesn’t always help the investor choose the right fund,
mainly because fund riskiness varies enormously within sectors. In August 2014, for example,
annualised volatilities of general equity funds (domestic, global and regional) ranged from 6.5 to 20.2.
Excluding resources funds, this covered two-thirds of all three year volatilities. Based on volatility, the
least risky general equity fund (6.5) was less risky than some multi-asset low equity funds (which
ranged up to 6.9). A risk assessment that puts an investor in the “general equity” category, therefore,
actually provides very little guidance – the funds in the sector range from low to high volatility.
Another problem is that volatility changes over time. In 2003, for example, the range of three
year volatility figures for general equity funds was 14 – 18. By December 2006 this had dropped to
the narrow range of 10 – 14. By December 2008, following the fourth quarter stock market crash,
they had climbed to 14 – 21, and by 2011 they were up to 14 – 28.Volatilities then narrowed again:
all but three of the 134 General equity funds with three or more years of history were in the 7.0 to
14.0 range at the end of December 2019. The coronavirus-triggered crash of March 2020 and
subsequent market recovery, however, has again sent volatilities soaring. At the end of July 2021,
over 90% of the funds in the SA General—Equity category had volatilities greater than 14.0 –
which was the top of the range in December 2019.
Shifting volatilities makes it difficult to use quantitative measures of risk when assessing
funds: a fund or sector that looks low risk today might look high risk next year.
One reason that the industry favours sector-based recommendations is that the relative riskiness
of sectors (based on volatility) tends to be fairly constant: although volatility ranges might shift, the
averageincomefundisalwayslessrisky than theaverage generalequityfund. Butthisispainting
with a very broad brush: sector-based recommendations are of little help when narrowing fund
selections. Matching a fund’s risk profile (conservative, moderate, aggressive) to an investor’s risk
profile is therefore only a first step. To fine-tune selections it is necessary to look at fund mandates,
historical volatility or risk-adjusted returns (on a fund basis), and sectoral and asset allocations.
Risk and Reward
It is a universally accepted principle of investment that risk rises with the potential for higher
returns. Put more simply: the greater the chance you can make big money, the greater the chance
you can lose your shirt.
It’s important to remember that risk is not necessarily rewarded: some high-risk funds consistently
deliver mediocre returns. A high-risk investment that declines in value but later recoups its losses and
climbs to new heights will reward investors who are abletorideout thevolatility. Butthere arealways
tempting investments with historically high risk/return profiles that, due to economic or industry
changes, fail to generate returns for extended periods. Such “high risk/low return” investments are the

105
Profile’s Unit Trusts & Collective Investments — Understanding Unit Trusts