In early December, the Canadian Securities Administrators (CSA) released its final risk classification methodology for determining the investment risk level reported in the Fund Facts (for mutual funds) and the newly introduced ETF Facts (for ETFs) disclosure documents. The CSA’s finalized rule, which will become law next September, is only a marginal improvement over the current standard. The new methodology will not inform investors meaningfully and may well mislead them.
Risk in these documents is addressed in three sections. One shows a fund’s year-by-year returns for the past decade – with numbers on a bar chart. This can be effective if – like today – a bear market has occurred in the past decade. If we don’t have another bear market before 2019, the 2008 bear market losses will disappear. This could mislead investors into thinking that a fund presents much less risk than it does.
Another section shows a fund’s best and worst three-month returns since inception. Although this section isolates downside risk (good), the information suffers from the same issue as does the yearly returns. It captures only the best and worst three-month periods over the past 10 years.
The third section is the subject of the CSA’s recently finalized risk classification method. This information illustrates risk by mapping a fund’s trailing 10-year standard deviation to a five-point descriptive risk scale ranging from low to high. This method is good in that it creates a standard (lacking today) that will be applied to all funds and ETFs, but will fail to inform investors of the true risk involved in any investment. Although the CSA has tested Fund Facts with groups of investors, the CSA didn’t test how people interpreted the five-point risk scale and how that matches up with reality. Simplicity does not equal effectiveness.
I made two submissions to the CSA on this issue. I proposed a method that I’ve been using with real investors in real situations for almost 20 years that shows an investment’s past bear market losses and recovery times. I’ve been applying this method to portfolios, not just individual products. The CSA rejected this approach, arguing that it is biased by a fund’s inception date – a problem, the CSA states, that is not solved by backfilling benchmark data. I couldn’t disagree more.
My first column in this space was on Fund Facts. Here is what I wrote about its risk section almost a decade ago (before the 2008-09 global financial crisis):
“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 of your money in stocks, you could lose half of your investment or more. That has happened before and can happen again.’ Too scary? OK, maybe a chart showing rolling returns or past declines in the fund’s benchmark might drive the point home. Something – anything other than ‘moderate risk’ – is needed (ideally, in a numerical context) to help investors better grasp risk.”
My CSA submission is the same as my 2007 proposal. My suggested communication was a little tongue-in-cheek, although I have used that phrasing verbally with clients. It provides clients with an accurate, forward-looking and easily understood method of communicating risk. Something like “moderate risk” never will be as informative.
Dan Hallett, CFA, CFP, is vice president and principal with Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.
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