Following a compliance review, which found that many investment fund managers are using discretion to help set their funds’ investment risk classifications, the Canadian Securities Administrators (CSA) is issuing new guidance to firms on the practice.
In a staff notice, the CSA reported that a review of 45 fund managers found that, between 2018 and 2024, almost two-thirds of managers had used their discretion to alter fund risk ratings.
CSA rules require fund managers to use a prescribed methodology — based around the standard deviation of fund returns over 10 years, and standardized risk categories — to calibrate risk ratings for mutual funds, ETFs, and alt funds.
While that methodology was mandated to improve the consistency and comparability of risk ratings for investors, the CSA also allowed fund managers to incorporate some discretion into their fund classifications — although discretion can only be used to increase a fund’s risk rating beyond the classification implied by the required methodology, it can’t be used to re-classify a fund to a lower category.
According to the regulators’ notice, the common reasons that firms gave for revising ratings using discretion included that the methodology placed the fund on the verge of a higher risk category; to keep a fund’s rating in its existing category (when the standard methodology would have moved it into a lower risk category); to ensure that comparable funds had the same ratings; and, in the anticipation of higher market volatility.
The review also found that about 60% of the fund firms it reviewed had policies in place to guide the use of discretion in risk ratings; approximately 25% used discretion, but had no policies on its use; and, 15% had no policies, but also hadn’t used discretion to adjust ratings.
To assist in the future use of discretion in these exercises, the CSA also issued new guidance, which recommends that fund managers adopt specific policies and procedures on risk classification and the use of discretion.
In that guidance, the CSA said that fund managers “should consider whether it is reasonable to exercise discretion,” in setting risk ratings.
“In particular, [managers] should consider the standard deviation calculation and determine whether the investment risk level is appropriate given the type of fund, the types of investment strategies used, the asset class, general market performance expectations and abnormal return periods,” it said.
Additionally, the regulators stressed the importance of “consistency in the use of discretion” — and they noted that funds are required to keep records on these kinds of decisions to document the use of discretion.