Steer clear of ‘risk-rated’ funds

Risk-rated funds have gained in popularity as the end of the year approaches. But before you dive in, Tim Bennett explains what you need to watch out for.

As the end of the year approaches, one group of funds is getting something of a new lease of life so-called risk-rated' funds. Many advisers are recommending them as a way of ensuring they comply with the Financial Services Authority's retail distribution review (RDR). But beware: there are traps for the unwary.

The idea seems sound enough. Product providers such as Standard Life (the MyFolio range) and Skandia (the Spectrum range) have come up with funds that are supposed to meet an individual investors' stated risk preference.

Standard Life, for example, offers 15 funds, each with a different risk rating assigned by an independent agency. All an adviser then has to do is document a client's risk profile (from low to high, with various shades in between) and appetite, then recommend one or more suitable funds from the range. It all sounds nice and simple the adviser gets paid for recommending the fund, and you avoid the hassle and expense of trying to build a portfolio yourself. So what's not to like?

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Firstly, it's not clear whether all investors properly grasp what risk actually is, particularly in the context of today's low inflation environment. There's not just the risk of losing money, there's the risk of not making enough. For example, as Tom McPhail of Hargreaves Lansdown notes in The Daily Telegraph, if you're after a return of inflation plus 3% these days, you'll need to take quite a bit of risk. Pick a low-risk' fund and you may end up disappointed.

Next, what is low risk today won't necessarily remain so tomorrow. In the past, for example, sovereign bonds have been classed as low risk. Yet with government debt levels high and government bond prices at record highs, it's hard to say they are low risk now.

Regardless of the nature of the investment, your own circumstances matter. As Bruce Moss of financial planning software group eValue FE notes in FT Adviser, the riskiness of any given fund varies according to how long you plan to hold it for. "For example, equity funds will be more risky the shorter the term during which they are invested."

Perhaps the biggest danger is that investors and advisers use the labels as a shortcut and don't stop to consider other factors: most importantly, how much the fund in question costs. After all, you can't predict the future, but you can make sure you don't overpay for potentially lukewarm performance.

Don't make your investments on the basis of a traffic light system: get under the bonnet and ensure the fund does what you need it to.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.