Proposed document skimps on illustrating risk and giving suitability guides

By Dan Hallett | Mid-November 2007

In this space and elsewhere, much has been written about the Joint Forum of Financial Market Regulators’ proposed Framework 81-406: Point-of-Sale Disclosure for mutual funds and segregated funds. Its proposed two-page Fund Facts should be examined in a very simple context. The merit of any addition to the already thick pile of required mutual fund disclosure should be evaluated on its improved ability to inform inves-tors.

Measured against this simple benchmark, Fund Facts, as proposed, fails.

There are many aspects of Fund Facts that are worthy of comment and analysis, but I will focus on “risk” and “suitability.” These are hot-button issues because they are at the heart of most lawsuits filed by disgruntled investors. Regrettably, this is also where Fund Facts is weakest at informing investors.

The sample Fund Facts found in Appendix 1 of 81-406 illustrates a hypothetical Canadian stock fund. The document defines risk as up and down swings in value, and communicates this to investors by indicating where the fund falls on a six-point risk scale, from “very low” to “high.” The sample fund is listed as having “moderate” risk.

But what does this really tell investors? That it’s three notches above “very low” but two below “high”? It’s meaningless. The scale should at least include “risk-free” at one end and “speculative” at the other. Investors would then have a hope of grasping, in very broad terms, the fund’s potential risk. Improving the scale along these lines would be a step in the right direction, but considering that Fund Facts is being proposed as the only mandatory point-of-sale disclosure, this would still not be good enough.

Then there is the issue of how risk is measured. There are several methods. Fund Facts uses volatility, but my years as an advisor and analyst have taught me that the frequency and magnitude of declines in value captures perhaps the most important definition of risk for individual investors.

Conceivably, a risk summary along these lines might be better: “If you put all your money in stocks, you could lose half your investment or more. It has happened before and it can happen again.” Too scary? OK, perhaps a chart showing rolling returns or past declines in the fund’s benchmark may better drive the point home. Something — anything — other than “moderate risk” is needed (ideally in a numerical context) to help investors better grasp risk.

This brings us to suitability. Investments should be chosen (and portfolios structured) based on a client’s return target, risk tolerance, time horizon, income needs, tax status, legal issues and special circumstances. Risk tolerance is arguably the most important of these factors because, in my experience, investors almost always overestimate their ability to tolerate bear market declines. Interestingly, this holds for both novice and sophisticated investors. Fund Facts has to improve its risk illustration considerably before it can even attempt to provide guidance on suitability.

Yet, for the hypothetical Canadian stock fund, Fund Facts boils suitability down to vague descriptions (i.e., suitable for a long-term investment), with a highlighted warning not to buy the fund if you need steady income. This, again, is not specific enough. Is “long-term” five, 10 or 20 years? And this may send the unfounded message that stock funds have no place in the context of income-oriented portfolios.

I wholeheartedly support the Joint Forum’s desire to provide simpler, clearer disclosure. But I’m afraid that in the spirit of simplicity (Fund Facts reads at a Grade 5 level), the proposed document will leave investors no more knowledgeable than they are today.

More significantly, Fund Facts skimps on illustrating risk and defining suitability guidelines — areas of critical importance to investors, advisors and dealers. IE

Dan Hallett, CFA, CFP, is president of Dan Hallett & Associates Inc. in Windsor, Ont., which provides a list of recommended mutual funds and investment research to financial advisors.