Calvin Tso of HSBC explains the main features, characteristics, objectives and risks of risk-controlled funds, as well as looking at who these types of products are suitable for.

Date: Apr 2011

Tags: Volatility, Risk, Correlation, Asset allocation, Equities, Suitability

• To get access to Greater China while managing the risk to ride the market cycle involves a risk-controlled, dynamic asset allocation model
• Correlation between equity market performance and volatility is clear, so if a fund is managed by looking at volatility to control the risk level, investors might be able to avoid most of any downturns
• The problem in many cases with investing is that it is difficult for many people to implement a lot of the techniques which they know to be right
• However, if the risk-control process fails, then the fund might perform worse than other, more traditional, equity funds

According to Calvin Tso in an interview, the main advantage for investors of the bank’s risk-controlled fund is providing an opportunity for them to get access to Greater China while managing the risk to ride the market cycle.

To achieve this involves a dynamic asset allocation model, he explained, where the fund can allocate between equities and cash instruments.

So in situations where there is normal volatility, the fund might allocate up to 100% into equities; and when the trend is suggesting that there is a bear market, it is possible to fully invest in cash equivalents.

The driver behind risk-controlled products

Tso said that history helps explain much of the rationale behind such risk-controlled funds.

Correlation between equity market performance and volatility is clear, he said – so in bull markets volatility is low, rising when the peak of a bull market approaches, and then shooting up when the market crashes.

As a result, he explained, if a fund is managed by looking at volatility to control the risk level, investors might be able to avoid most of the downturn.

Suitability

A key advantage of creating this product in a fund format, said Tso, is to enable investors to move in and out of it at any time. Plus, it is adds a discipline to the process.

The problem in many cases with investing, he said, is that it is difficult for many people to implement a lot of the techniques which they know to be right.

Key risks

However, if the Greater China market doesn’t perform, then Tso said the fund won’t perform.

At the same time, if the risk-control process fails, then the fund might perform worse than other, more traditional, equity funds.

Yet for the risk control mechanisms to fail, Tso said it will require a breakdown in the relationship between volatility and the market cycle. Also, if longer-term trend analysis stops working, this will lead to problems.