Since the Canadian Securities Administrators (CSA) mandated the inclusion of risk ratings on Fund Facts documents, there has been much debate about how to determine the risk rating. In December 2013, the CSA issued a request for comment on their proposed risk classification methodology to be used in Fund Facts documents. Since then, they’ve reviewed responses, resulting in a release on Dec. 10, 2015, which contained a synopsis of the comments and responses as well as several changes to the proposed rules. Table 1 shows a summary of some of the key changes in the new proposal:
Given the amendments to the proposal, here is a summary of how the fund risk ratings will be determined:
- If a fund has 10 years of history, use the 10-year standard deviation (SD).
- If a fund has less than 10 years of history, use the fund’s returns that are available, and then use a proxy index to fill in the history up to 10 years.
- Apply the standard deviation numbers shown in Table 2 to determine the risk rating:
So what does this proposal mean for the investors and advisors who will be using the risk ratings? The key change is the use of the 10-year standard deviation as opposed to the 3-year and/or 5-year SD, so I’ll explain some of the effects this will have.
10-year standard deviation
It’s been well-documented and widely agreed upon that standard deviation is the most appropriate single risk measure to use in determining a risk rating on the basis that it’s 1) easy to understand, 2) a good descriptor of the total price volatility of a fund, 3) currently broadly used, and 4) the calculation is simple and cost effective. The issue is what time period to use.
The current IFIC guidelines suggest using a 3-year and 5-year rolling average SD if the fund’s SD is “materially” different than its index. So while the fund’s risk rating will look similar on the surface (still based on a five-point scale ranging from Low to High), the underlying numbers could be quite different. Of funds that have 10 years of history, 74% have a higher 10-year SD compared with the rolling 3-year SD, but only 39% of funds have a higher 10-year SD compared with the rolling 5-year SD. So if the ratings are based on the 10-year SD, you would expect a lot of movement in the risk ratings.
We estimate that between 40% and 50% of funds will be changing risk ratings based on the new proposal. This is very much an estimate, because most of the risk ratings will be dependent on the indices used for proxy data. This is because just under 20% of mutual funds have 10 years of history, which means that 80% of funds will be using an index to fill the gap.
Despite the changes that using the 10-year SD number will bring, it still has several advantages over the 3-year and 5-year numbers. Perhaps the most important one is the fact that by using the 10-year number, it’s very unlikely that the risk ratings are going to change from year to year. The following graph of a sample fund in the U.S. Equity category shows how the 3-year and 5-year SD can change dramatically according to prevailing market conditions, while the 10-year SD remains fairly consistent over time.
We’re not sure exactly what the CSA’s timeline will be for implementing the new rules, but the comment period for this proposal ended in early March 2016, so it will be interesting to see the breadth of responses and, of course, the CSA’s reaction. This is likely to be the last “request for comment,” so the next step will very probably be the release of the official guidelines and the timeline for implementation.
Reid Baker is Director, Analytics & Data at Fundata Canada Inc., a leading source for investment fund information. He is Chairman of the Canadian Investment Funds Standards Committee
Notes and Disclaimers
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