Risks hide in different places, in politics economics and elsewhere. Investing by its very nature is risky, as investments can be affected by shocks to the financial system, such as the financial crisis of 2008 or more recently the Covid crisis.

European Commission regulations require fund managers to publish scores for their funds, known as ‘Synthetic Risk and Reward’ or SRRI numbers. These are designed to give investors an idea of the appropriate level of risk and return they might see in the future.

Advocates of the measure highlight its use as a standardised risk assessment tool across all funds and for understanding how risks vary across different asset classes.

However, the value of SRRI as a risk measure has been questioned, because it looks back at fund returns over past years and uses this to estimate how significantly they might fluctuate in the future.

This has led to claims the measure provides no real guidance to future performance.

Moreover, critics of SRRI suggest that five years is an insufficient period to assess the performance of a fund through a full market cycle.

UNDERSTANDING SRRI 

The SRRI score is designed to provide a consistent calculation and presentation of risk information for all UCITS funds, allowing investors to compare products using an easily understood format.

It is used to classify investment funds into one of three different risk categories (low risk, medium risk and high risk) and forms an integral part of the ‘KIID’ or ‘Key Investor Information Document’ which is available on every fund via an investment platform provider’s website or on the fund manager’s website.

It uses a numerical scale between one and seven (which represents the historic volatility), with one meaning low/risk reward and seven the highest level of risk but with the potential for a higher level of return.

The volatility is calculated using weekly past returns of the investment fund over the last five years.

For example, Fundsmith Equity Fund (B41YBW7) scores ‘five’ for its risk and reward profile. It says: ‘This fund is ranked at “five” because funds of this type have experienced medium to high rises and falls in value in the past. The underlying investments are, however, in large companies with shares that are, in most cases, highly liquid.’

PROS AND CONS

Critics of SRRI have argued that to create a standardised process for matching investors to funds, risk assessment tools have tended to simplify risk to the single measure of volatility.

However, given volatility’s poor predictive power, it is both a weak proxy for risk and an unreliable way to predict severe capital loss. Given this, it has been suggested that SRRI on its own is of limited used in matching funds to investors.

The calculation of volatility makes two big assumptions – that returns are normally distributed and correlations are stable. Neither is true.

As a result, the SRRI score does not fully describe the distribution of returns. In essence, investors who simply use the SRRI score are attempting to navigate the future investment landscape using only their rear-view mirror.

UNRELIABLE MEASURE

Sadly, an SRRI score should not be relied upon as a useful measure of risk because the bands are too wide.

The lower scores are essentially cash and at the top end it isn’t common to see a fund with a ‘seven’ score. However, scores four to six are too broad, with historic volatility ranging from 5% to 25%.

That means you end up with funds having the same score but potentially a different outcome. The vast majority of products cluster between a score of four to six whether they are 10% equity or 100% equity.

OTHER MEASURES TO CONSIDER

There are a few other measures investors can use alongside SRRI to gain a more holistic picture of the risks associated with a specific fund. These include the information ratio and the upside/downside ratio.

While the SRRI score is easily obtainable, the information ratio and upside/downside ratio are harder to find.

Unless you pay a premium subscription to Morningstar, the only way you’ll typically get this information is if a fund publishes a Morningstar managed investment report on its website such as this one on Fundsmith Equity Fund. Even then, there is no guarantee it will contain all the information you want.

INFORMATION RATIO

The information ratio seeks to identify whether the active risk taken by the manager relative to the benchmark has been rewarded with outperformance. It is an assessment as to whether the active bets in the portfolio have paid off.

An information ratio above 0.5 is considered good. A figure above 1.0 is considered excellent.

UPSIDE/DOWNSIDE CAPTURE RATIO

The upside/downside capture ratio is one way to evaluate a fund’s historical performance during both bull and bear markets.

The measure indicates whether a particular fund has outperformed a broad market benchmark during periods of market strength and weakness, and if so by how much.

An upside capture ratio over 100 indicates a fund has generally outperformed the benchmark during periods of positive returns for the benchmark.

Conversely, a downside capture ratio of less than 100 indicates that a fund has lost less than its benchmark in periods when the benchmark has been in the red.

‘A down market is defined as those periods (months or quarters) in which market return is less than 0,’ explains Morningstar. ‘In essence, it tells you what percentage of the down market was captured by the managed investment. For example, if the ratio is 110%, the managed investment captured 110% of the down market and therefore underperformed the market on the downside.’

Disclaimer: Daniel Coatsworth who edited this article has a personal investment in Fundsmith Equity and Fidelity Index World

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