Investors and advisors may have to watch out for inconsistent and potentially misleading fund risk ratings
As financial markets officially go beyond the 10-year mark following the 2008-2009 financial crisis, it may be time for investors and advisors to take a closer look at investment fund risk ratings.
A recent commentary by Fundata suggested that the CSA Mutual Fund Risk Classification Methodology, which managers first started using over two years ago, suffers from major problems that lead to inconsistent and potentially misleading risk ratings.
The first problem concerns the static standard deviation (SD) bands used to assign risk ratings. As explained by Brian Bridger, CFA and vice president for Analytics and Data at Fundata Canada, the methodology requires managers to calculate a 10-year SD for their funds, using proxy data if necessary. Managers must then refer to a risk-rating table to determine the appropriate risk label for each fund based on its 10-year SD.
“[T]he regulators argued that 10-year volatility levels were consistent over time, thus eliminating the need to shift the bands based on prevailing market conditions,” Bridger said. “However, the low volatility environment of the past three years has cast serious doubt on this assumption, something that was predicted over two years ago.”
He noted that since the initial establishment of the SD banks in 2016, the average SD for each category set out by the Canadian Investment Funds Standards Committee (CIFSC) has gone down. Out of 34 categories that had a 10-year track record in May 2016, 18 saw the average fund shift down by one SD band. These include:
- Natural Resource Equity (from 22% in May 2016 to 17.5% today);
- High Yield Fixed Income (from 6.6% to 4.4%);
- Canadian Equity (from 12.8% to 9.2%);
- Emerging Markets Equity (from 18% to 13%); and
- Global Neutral Balanced (from 7.3% to 5.6%)
“For more than half of funds in Canada, the static SD bands now point to a rating that does not accurately reflect the riskiness of the investment,” Bridger said.
The other issue involves upward discretion, a mechanism by which fund managers are allowed to tweak their funds’ risk ratings upward (or not lower risk ratings) during periods of low volatility when ratings could appear inappropriately low. The problem with the system, Bridger noted, arises when managers do not act in unison; in such cases, similar funds end up having different risk ratings.
“In 2017 there were around 210 risk rating decreases, compared with only 70 increases, he said. “In 2018, the numbers were closer to 200 and 80, respectively.”
Thus far in 2019, Bridger reported, over 145 funds have seen a risk-rating decrease, as opposed to just five with increases. Risk-rating reductions have been applied to over 12% of funds, and decreases outnumber increases by a ratio of 29 to 1. The industry is on pace to see another 300 risk-rating decreases by the end of the year.
“Clearly, more and more managers are taking advantage of the low-volatility environment to reduce their fund’s risk rating rather than using upward discretion,” he asserted.
