Risk ratings and risk targets – are you running a risk?

We’re now navigating the potentially volatility-inducing policies of a second Trump presidency. As a result, there’s likely to be even greater scrutiny on whether an investment solution can deliver suitable outcomes in line with an investor’s appetite for risk.

Meanwhile, third-party risk ratings remain as popular as ever. But what do the numbers in a risk rating mean? Can they evidence suitability? And how does a risk rating differ from a risk target?

Running the risk

In 2024, research by NextWealth found that 57% of financial advisers relied heavily on third-party risk ratings when recommending investment solutions for their clients. The popularity of these ratings has surged at the same time as the number of people using multi-asset investment solutions has increased.

Using a risk-rated investment solution is seen as a great way to demonstrate investment suitability aligned with an investor’s risk tolerance. In parallel, advisers can now embed risk ratings within their advice process more easily than ever thanks to the technological advancement of risk-profiling tools and investment research tools. But what is a risk rating and how is it calculated?

A calculated risk

A risk rating is a ‘moment in time’ quantitative assessment based on the expected volatility of an investment solution. A risk rating:

• looks at the expected volatility of the asset classes held within the solution
• weighs the expected volatility against the proportion of the asset classes held
• considers any assumed investment horizon.

Any investment solution can pay a third party for a risk rating. The quantitative assessment can support an advice process by making it easier to align a solution with an investor’s overall appetite for risk.

So, if a risk rating is just a snapshot of the fund or portfolio at the time it’s assessed, what does this mean for its risk profile in future? Taking an example investment solution with a risk rating of ‘5’, how confident can an adviser be that it will stay a ‘5’? And how would it react in times of market stress and heightened volatility? This is where a risk-targeted approach differs and can help support advice processes in a more robust fashion.

Hitting the target

Taking a step back, what does this really mean for advisers?

1. The risk target can allow advisers to better manage their clients’ expectations as the expected returns are associated with the risk the client is taking.
2. The risk target can be used to enhance capacity-for-loss conversations, particularly by focusing on any potential downside risk.
3. The risk target and expected returns can also be used as a basis for more accurate assumptions in any cashflow modelling processes.

However, perhaps one of the biggest advantages of a risk-targeted approach is that the investment is continuously managed in a way that is aligned with an investor’s appetite for risk, eliminating the threat of any potential drift.

Risk on? Risk off? Always risk targeted

So, the theory is sound, but let’s consider a real-life example by looking at the Quilter WealthSelect Managed Active 5 Portfolio and considering its risk-target objectives.

The portfolio is rebalanced on a quarterly basis, but the portfolio management team can also undertake ad hoc tactical rebalances at their discretion to take advantage of market opportunities. The rebalances enable the portfolio managers to implement their latest investment conviction, whilst also keeping a sharp focus on the risk profile of the portfolios.

At each rebalance, the portfolio managers ensure that the portfolio continues to target its defined range of volatility. The chart below demonstrates how this is paramount in the portfolio managers’ decisions. As you can see, the portfolio has remained within its volatility range at every quarterly and tactical ad hoc rebalance since launch in 2014.

Source: Quilter as at 14 January 2025. Ten-year forward-looking volatility of the portfolio at time of each rebalance over period 24 February 2014 to 14 January 2025. The WealthSelect Managed Active Portfolios launched on 24 February 2014 and the WealthSelect Responsible and WealthSelect Sustainable Portfolios launched on 8 March 2022.