Risk Rated Funds Are Broken

PUBLISHED Oct 31, 2022, 8:05:20 AM        SHARE

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We are now in an environment in which bonds are riskier than equities, spelling trouble for risk rated funds

I have a piece being published in CityWire this week which I think might make some waves. Its message is that passive and active risk rated funds, in which tens if not hundreds of billions are invested worldwide, are broken and could remain so for years. The reason? High inflation.

By risk rated funds I mean balanced or multi-asset funds, active or passive, whose risk is measured, explicitly or otherwise, by the percentage held in bonds.

In other words, they include passive balanced funds such as the Vanguard LifeStrategy funds or the BlackRock Consensus funds. And the many active risk rated fund ranges whose funds are assigned a risk rating, based on short term volatility, from 1 (very low risk) to 10 (very high risk). In reality, balanced/multi asset funds are assigned ratings between 4 and 7.

The reason these funds have proliferated in recent years is that we were in an environment in which equities and bonds were generally performing well (Chart 1). Since bonds, as measured by short-term volatility, are lower risk than equities, so-called risk rated fund ranges could be built whose performance was consistent i.e. a low risk rating meant both low return and low risk. Conversely, a high risk rating meant high returns and high risk.

This conducive backdrop was thanks to inflation that had either been falling or was low/stable. Such an environment was great for both equities and bonds. However, things have now changed, as they tend to do every few decades (Chart 2). Inflation is now high, and while it may fall in the medium term as a result of a recession, it could bounce back and remain generally high for years.

There is precedent. The second half of the sixties saw inflation rise (in the US it rose from around 1% to around 5%), then fall as a result of a recession in 1969/70, then rise again and stay high throughout the 70s, exacerbated by two energy crises.

Economic theory also suggests that high inflation could remain a problem for years. Economies have been on an unsustainable bender - a bender being something that, by definition, is unsustainable - for four decades thanks to generally falling inflation. The hangover could last for years and will involve a period of high inflation. This is a crude summary of a valid theoretical argument that I will not go into here.

The fundamental flaw in risk ratings and fund ranges that utilise the ratings is that they assume that short term volatility is a good measure of risk. This may be true for prolonged periods, including that from 1981 to 2020, but it is not always the case (Chart 3). During periods of high inflation, bonds perform worse than equities, and yet on the basis of their short-term volatility they are deemed low risk. Indeed, if you calculate volatility using 30-year rather than 1-month returns, bond volatility is in fact higher than that of equities.

Since June 2020, the supposedly low risk Vanguard LifeStrategy 20% Equities fund has fallen by 13% compared with its high risk (80% Equities) equivalent which has risen 11% - in real terms the numbers are around -25% and -1% respectively.

In a high inflation world, such 'upside down' performance is likely to continue (Chart 4). Investors in balanced/risk rated funds and intermediaries who use the funds may need to have a rethink.

Chart 1: The last four decades, at least until recently, were fantastic ones for balanced/risk rated funds img

Chart 2: A 50/50 US balanced fund has had multi-year periods of poor performance img

Chart 3: The sixteen years from 1965 to 1981, however, were dreadful ones for balanced/risk rated funds img

Chart 4: The last two years have been bad, but things could remain bad for many years img

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
© Chimp Investor Ltd
Originally Posted in Chimp Investor

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