This blog post is an executive summary of a more detailed article on Risk Management and the ESMA Risk Scale.
European Securities and Markets Authority (ESMA) Risk Scale
The ESMA risk scale has its origin in European Union (EU) legislation in relation to Undertakings for Collective Investment in Transferable Securities Key Investor Information Documents (UCITS KIIDs). The ESMA Risk Rating methodology uses a seven point scale based on 5-year annualised volatility ranging from band 1 (annualised volatility between 0% and 0.5%) to band 7 (annualised volatility above 25%).
Keys to Delivering a Target-risk Multi-Asset Fund
The keys to delivering a multi-asset fund which targets a specific ESMA risk range are:
- Stand-alone risk measurement; and
- Active monitoring of the risk.
It’s important to ensure exposure to a diversified portfolio of asset classes like equities, bonds, property, commodities, currencies, and cash. The lower the correlation between each pair of assets, the greater the level of diversification in the fund and ultimately the lower the risk of the combined portfolio of assets.
Stand-alone risk is a useful means of assessing what happens to the risk of a multi-asset portfolio when all of the component assets become perfectly positively correlated. It’s a useful means of estimating the upper limit on the risk of a multi-asset fund when the volatilities of the component assets are relatively stable.
Active Monitoring of Risk
One of the key drivers of the size of peak-to-trough falls in value of a portfolio is the volatility of that portfolio. For this reason and in order to deliver on the ESMA risk objective of a portfolio, it’s important to ensure that the volatility of the portfolio does not exceed the upper end of the ESMA risk range. This could be done in at least two ways: (i) Monitor the 5-year annualised, rolling, weekly volatility of the multi-asset fund; and (ii) Monitor the annualised, rolling, 20-day volatility of the multi-asset fund. While the first method is very much in line with the ESMA methodology, the second method is a more short term measure of volatility. Method (ii) may provide an early warning signal that the volatility of the portfolio is increasing very rapidly in the short term.
If the realised volatility of the underlying asset classes falls and remains low for a long period of time, the risk of the multi-asset fund may fall below the lower bound of its target risk range. Equally, even if the volatility of the component asset classes remains unchanged, a significant fall in the pair-wise correlations between the asset classes which persist over time, may cause the lower bound of the ESMA volatility range of the fund to be breached.
Keeping within the ESMA Risk Range
Diversification and active monitoring of the risk of a multi-asset fund will significantly reduce the probability of a multi-asset fund exceeding the upper limit of the ESMA risk range. Preventing a multi-asset fund from dipping below the lower limit of its ESMA risk range may be constrained by a prohibition on leverage or by requirements of prudent diversification.
The views and opinions expressed in this article are those of John Caslin, Head of Investment Proposition at Friends First and Patrizia Libotte, Director of Multi-Asset Funds at Friends First.
Download the full Risk Management and the ESMA Risk Scale technical guide.