Calvin Tso of HSBC explains how and where risk-controlled funds fit within investor portfolios, and how wealth managers can sell them appropriately.

Date: Apr 2011

Tags: Volatility, Risk, Asset allocation, Portfolio construction, Equities, Suitability

• Given that China is still an emerging market, the amount of volatility which exists for investors makes downside risk management particularly important
• Most investors don’t have the time, skills or information to time the market, so rather than using what they see as more complicated products such as hedge funds, risk-controlled funds can give them a long-term investment option
• Investors need to be comfortable with the broad Greater China market, with the long-term nature of the product, and with the possibility that the risk-controlled mechanism might fail

Given that China is still an emerging market, the amount of volatility which exists for investors – especially in a bear market – makes downside risk management via a risk-controlled fund particularly important, said Calvin Tso in an interview.

The best outcome for investors is obvious, he said: the Greater China performs well, in turn creating long-term capital growth and higher risk-adjusted returns through the fund.

The worst scenario, meanwhile, is that the market doesn’t perform, and having a risk-controlled process doesn’t add any value. This might also lead to a capital loss, he added.

Opting for a risk-controlled fund

For individuals who already have access to Greater China via long-only funds or direct equities, the addition of a risk-controlled fund enables them to avoid major downturns, explained Tso, therefore producing a better risk-return profile.

So adding such a fund into an existing portfolio would enhance the overall portfolio efficiency and profitability, he said. During a downturn, for example, when volatility is high, Tso said the fund can reduce its equity allocation to zero, sitting in cash and waiting for the entry point.  

As a result, he said risk-controlled funds are suitable for investors with a long-term view of Greater China.

By contrast, if they hold a traditional equity fund for long enough, they also need to absorb the market cycle, and the funds cannot be dis-invested during a bear market, he explained.

Comparing capital protected funds

According to Tso, capital protected products usually have a fixed maturity date, therefore constraining the upside potential. Plus, investors pay for the cost of the protection.

But if an investor has definite targets, obligations or liabilities – and wants their capital to be protected at the same time – such a product would be much more suitable.
 
For investors who prefer the idea of a long term, open-ended fund to give them the up side, however, and who might want to take some risk, for example if they are in an accumulation phrase, they need to look at alternatives such as the risk-controlled approach.

Comparing hedge funds

At the same time, Tso said the majority of investors find hedge funds, or long/short strategies, difficult to understand.

A risk-controlled fund, on the other hand, takes a more common-sense approach, in terms of riding market cycles. And most investors don’t have the time, skills or information to time the market, he added, so rather than using what they see as more complicated products such as hedge funds, risk-controlled funds can give them a long-term investment option.

Ensuring suitability

When a wealth manager is looking to sell this type of product, Tso said there are some key elements to explain to investors.

First are the market risks – investors need to be comfortable with the broad Greater China market, in terms of believing that it is well-placed for the long term.

Secondly is the long-term nature of the product. Given that it targets the market cycle, he said investors cannot trade the fund.

Thirdly, he added, is the possibility that the risk-controlled mechanism might fail.