Understanding Investment Risk Washing
“Risk Washing” is the process of disguising or ‘mislabelling’ the true underlying risks underpinning an investment portfolio. Without understanding these fundamentals, investors can be exposed to risks that they may not have signed up for.
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Asset Intelligence an institutional research firm recently described this situation as ‘mislabelling’.
As explained by Asset Intelligence the majority of multi-asset funds are placed in one of three Investment Association (IA) sectors, which are defined by their exposure to equity markets; namely the IA Mixed Investment 0-35% Shares, 20-60% Shares and 40-85% Shares sectors.
However, this overlooks the exposure to other risky assets, such as emerging market debt (EMD), which are counted towards the fixed income exposure of multi-asset funds, but could be considered in the same risk risk category as equities.
“Assets such as high yield and EMD are fixed income assets and therefore don’t count towards the equity allocation of funds, but evidence shows they correlate closely to equities, particularly in periods of market stress,” said Robert Love, head of research and principal at Asset Intelligence.
If two assets have an expected correlation of 1.0, it means they are perfectly correlated, so if one gains 5% so will the other, and vice versa if they drop in value.
Lack of protection
According to Asset Intelligence, with a correlation of 0.77 and 0.79 respectively for local and hard currency EMD to global equities, as defined by the MSCI All Countries World Index, and 0.84 for global high yield bonds, allocating to these assets in the expectation they will offer real diversification if equities sell off shows a major flaw within multi-asset funds.
“By leaving them out of the fund’s ‘risk’ category it means investors are left exposed to assets which will act more like equities but which they assume are offering them protection,” said Love. “This is a poor outcome for clients who won’t know what risks they are really exposed to.”
A definition problem
Part of the problem stems from the IA sector definitions, which categorise funds by their exposure to equities, not other assets – however equity-like they be.
“Many multi-asset funds include many different asset classes, but by mislabelling these assets, they have been making investments in the part of their portfolio considered to be defensive, only to find it is anything but,” said Love.
He added: “It was a nice marketing idea to put a collection of assets into one fund and call it portfolio management, but the reality is that in many cases multi-asset funds offered don’t offer investors the risk profile they think they do.”
This short video succinctly highlights the all important issues for investors
In the video above James Penney of TAM Asset Management explains his concerns and highly recommends that investors become aware of the"Risk Washing" issues they and their investment portfolios could be taking.