Page 119 - Profile's Unit Trusts and Collective Investments 2021 issue 2

Investment Risk

a risk-free interest rate. This figure shows the “excess” return that a fund has achieved, and is also
known as the “risk premium”.
Step two shows the relationship between the risk premium and the level of risk taken. This is
calculated by dividing the excess return by the fund’s standard deviation. Obviously, the higher the
Sharpe ratio the more favourable the risk/reward profile of the portfolio.

Ave. annual rate of return Risk-free rate Risk premium Std. deviation Sharpe ratio
25% 5% 20% 10% 2.0
Fund A
50% 5% 45% 30% 1.5
Fund B
The example shows two funds, A and B, where fund A has produced only half the average
annual return of fund B. Fund B also has a much higher level of volatility, however, as shown in the
standard deviation.
The Sharpe ratio shows that fund A, although it produced a lower return, had a better
risk/reward relationship.
The Sortino ratio is similar to the Sharpe ratio, but with a focus on the downside risk of a fund rather
than overall risk. Where the Sharpe ratio uses overall portfolio volatility, the Sortino ratio quantifies
downside risk. Frank Sortino developed the ratio in response to the theory that investors are not
equally concerned about upside and downsiderisk; they areprimarily concernedwith under performance
(downside risk). The Sortino ratio is often calculated using the inflation rate rather than a risk-free
rate, so that Sortino ratios greater than zero show that a fund has at least beaten inflation.

Risk Profiling
Fifteen years after FAIS was implemented the industry is still debating the definitions of "risk,"
“risk profile” and “risk profiling.”
From the point of view of financial advisors, risk profiling is not optional – the General Code of
Conduct (GCOC) requires intermediaries to take into account a client's ability to bear any risks
associated with a product and the extent to which a client is able to understand the risks involved
in an investment (see sections 7 and 8 of the GCOC). Risk assessment must be considered before
advice is given.
In discussing risk with a client, an intermediary must explore three distinct risk elements: risk
required, risk capacity, and risk tolerance (sometimes called risk appetite).
Risk required: the level of risk that needs to be shouldered in order to achieve a set
financial objective over a defined period (eg, the necessary rate-of-return) – this assumes
that higher returns can only be achieved with higher risk.
Risk capacity: the degree to which an investor's financial resources (both income and
existing capital) will allow the investor to shrug off market downturns and remain
invested (eg, a client must have sufficient assets, cash and income security not to be
forced out of long-term investments).
Risk tolerance: both the investor's willingness to be exposed to market volatility (the
danger of capital losses) and the investor's "nerve" – the ability to go the distance without
panicking during downturns.
Clear definitions of the terms "risk" and "risk profiling" are not included in the GCOC, possibly
because these words mean different things in the investment, life insurance and short-term
insurance contexts.
In the investment sphere, one of the challenges with risk profiling is that clients and
intermediaries often have different departure points. For many investors, risk is seen simply as the
danger of losing money (a reduction in capital). For the investment industry, however, inflation is
seen as a significant risk in long-term wealth-building – a reality that may not be sufficiently
appreciated by many investors. In short, there is not always alignment on the pervasive risk of
insufficient capital growth. In this context, the industry tends to assume that reductions in capital
are temporary (a result of market volatility that time in the market will fix), whereas many
investors are as rattled by "paper" losses as permanent "realised" financial losses.

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