Until now, investment fund managers have been able to use their own methodology to determine the risk ratings of their funds, which has led to inconsistencies and confusion in the industry. To standardize risk ratings, the regulatory agency association, the Canadian Securities Administrators (CSA), has been developing a risk-rating methodology in consultation with industry participants. It recently published its final amendments, and this will be used to calculate the risk ratings that appear in Fund Facts sheets and the soon-to-be-required ETF Facts for exchange-traded funds.
Mutual fund managers have generally used the methodology of the Investment Funds Institute of Canada (IFIC), while most ETF providers have used the Canadian ETF Association (CETFA) methodology (full disclosure: CETFA risk ratings are calculated by Fundata).
Similar to the CSA methodology, both IFIC and CETFA use standard deviation (SD) to measure risk. Unfortunately, both methodologies offer enough flexibility that funds with similar risk characteristics can end up with very different risk ratings. The new CSA policy will ensure that all mutual funds and ETFs will be using the same methodology, which will increase comparability and transparency while minimizing the possibility of manipulation.
When the CSA methodology was first proposed back in 2013, it was expected that a very high percentage of funds would move up at least one risk band. This was due to 1) the use of 10-year SD as opposed the 3-year and 5-year data being used in the industry at that time, and 2) revised volatility bands for each risk bucket. After receiving a large number of comments from industry participants about how these changes would be detrimental to the industry, the CSA altered the bands in its second draft in 2015 to lessen the impact. Now that the methodology has been finalized, and implementation has been set for September 1, 2017, we can run the numbers to see which funds might be affected.
The final amendments released by the CSA do not contain any material changes from the previous proposal. Firms will still be required to calculate the 10-year SD, and proxy data must be used to backfill history in cases where a fund does not have a 10-year track record. There are instructions for determining the reasonableness of the reference index; however, the choice of index is still at the manager’s discretion. Since the choice of proxy index could have a big effect on a fund’s final risk rating, this analysis will look only at funds with 10 years of history. Using the 10-year SD and the prescribed volatility bands (see table below), we can project the “new” risk ratings and see how they compare with the current risk ratings for each fund.
Keep in mind that this is analysis is being done assuming the new rules had come into effect today and that the data are as of November 30, 2016. It is also important to remember that a fund manager has the discretion to increase a risk rating if they feel the calculated risk rating does not capture the actual risk, but they do not have the discretion to lower a risk rating.
The initial fund list includes 1,275 mutual funds and 27 ETFs. Of the ETFs, all have a projected risk rating that corresponds with their current ratings. Notwithstanding the small sample size, as well my inherent bias with the current CETFA ratings, it looks like the current risk ratings for ETFs do a fairly good job of capturing the appropriate risk, according to the methodology.
For mutual funds, a total of 357 funds, or 28%, have a projected risk rating that is different from their current risk rating. Eighty of these, or 6.3% of eligible funds, are projected to increase their risk rating. Here is a summary:
- Equity funds are affected disproportionately when compared with the universe. 84% of the affected funds are equity funds, while only 59% of the initial universe are equity funds.
- US Equity funds have the highest total number of affected funds at 14 (13% of US Equity funds).
- Four categories have at least 16% of their funds affected. This includes Commodity, Energy Equity, Natural Resources Equity, and Financial Services Equity.
- Five funds will move up two risk bands, all of which will go from “Medium” to “High”
Keep in mind this just represents the potential risk ratings changes for funds with a 10-year track record. If we assume this sample is representative of the universe, we can expect close to 200 funds, mainly in the equity categories, to increase their risk rating when the rules come into effect.
At the other end of the spectrum there are 277 funds that currently have a higher risk rating than what is calculated. This is over 21% of funds that would be allowed to lower their risk rating under the new methodology. Here is a summary:
- Balanced funds and equity funds are most affected.
- Twelve categories have at least one third of their funds that could decrease their risk ratings.
- 30 funds could decrease their risk rating by two risk bands.
Now this does not mean that all managers will immediately lower the risk rating for these funds, because they do have the discretion to keep the ratings higher. However, understanding that lower risk ratings can increase the pool of potential investors and thus increase sales, it is logical to think that if some companies begin to lower their risk ratings, other will soon follow.
It will also be interesting to see what happens in 2017 when the volatility we saw during the financial crisis in 2007 and 2008 begins to drop out of the 10-year SD calculation. If we do not experience a spike in market volatility within the next year, the volatility numbers will begin to fall and inevitably, so will risk ratings. So what at first what looked like an attempt by the regulators to increase the risk ratings in the fund industry could potentially give managers the ammunition they need in order to lower the ratings on many of their funds. Stay tuned.
Brian Bridger, CFA, FRM, is Vice President, Analytics & Data at Fundata Canada Inc. This article is not intended as personalized investment advice. Securities mentioned are not guaranteed, involve risk of loss, and are subject to commissions.