How to measure and communicate investment risk is one of the investment industry’s “hot button” issues. Indeed, the Canadian Securities Administrators‘ (CSA) request for comment on this issue, as it pertains to investment funds, prompted 56 written submissions – including one from yours truly.

One of the many issues on which submissions are divided is whether fees should influence risk assessments in any manner. I think they should.

I’m the first to acknowledge the value of professional financial advice. I’m in my 20th year in this business, and I’ve seen how people can benefit from smart advice. But there is a limit to the value of advice. And although a lot has been written on how fees slice into returns, I rarely see or hear discussions on how fees affect risk.

Among my recommendations to the CSA was to measure risk separately for each of a fund’s series of units. For example, many funds offered by institutional money managers are available in two forms: one directly from the portfolio manager and another through a third party that sells through financial advisors paid by commission. The latter funds sport much higher fees than the former. I believe that significantly different fee levels result in materially different levels of risk – even for otherwise identical funds.

Just as an advisor promotes the benefits of his or her services, regulatory documents should calculate risk differently for each product and each version thereof. This is best illustrated using historical data. I examined the monthly returns for the S&P/TSX composite total return index from February 1956 through March 2014 while applying hypothetical management expense ratios (MERs) ranging from 0% to 2.5% per year.

Standard deviation – the prevailing measure of risk and the measure that the CSA proposes – is identical under all fee levels. So, in theory, you could apply a ridiculous fee of 10% per year and standard deviation in that case would be the same as when no fees apply. But the risks to which your clients respond most strongly – the frequency, magnitude and duration of losses – change dramatically in different fee scenarios.

With no fees at all, the S&P/TSX composite total return index’s worst periods saw it lose 43% over a nine-month period. Subsequently, the index took two years to recover. In other words, it was underwater for 33 months. Apply a 2% annual fee – roughly, the weighted average MER for Canadian mutual funds – and the amount of time underwater almost doubles to 56 months.

Let’s look at my study using another common measure of risk. When examining all of the “rolling” periods for the S&P/TSX composite total return index, a holding period of at least seven years would have kept investors above water. But apply a 2% per year fee and the required minimum holding period jumps to 10 years.

Many advisors bring tremendous value to their clients – value that often dwarfs the fees paid. But let’s not ignore the mathematical reality: higher fees equal lower investment returns and higher risk.

I just hope that regulators choose a way to measure and communicate risk to your clients that captures this reality.

Dan Hallett, CFA, CFP, is vice president and principal for Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.

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