CSA decides on standard deviation to classify riskiness of funds

Regulators have been considering the approach to assessing the riskiness of funds in upfront investor disclosure for several years now in response to concerns from investor advocates. To date, firms have been able to choose their own methodology for assessing risk levels. The CSA is mandating a standardized methodology in an effort to make that disclosure more useful and comparable.

“A mandated standardized risk classification methodology will provide for greater transparency and consistency of investment risk levels across mutual funds,” says Louis Morisset, chairman of the CSA and president and CEO of the Autorité des marchés financiers, in a statement. “The use of such methodology will allow investors to more readily compare the investment risk levels of different mutual funds.”

Although there was widespread support for the idea of introducing a standardized methodology, there has been a significant policy debate about the appropriate metric for assessing risk, with some investor advocates and others worried that relying on standard deviation could be misleading to investors. However, the CSA has decided that it is nevertheless the best option for a standardized risk rating methodology.

“Standard deviation is a good general measure of risk that can be applied to funds with widely varying investment mandates,” the CSA says in its notice. “Standard deviation can adequately capture many types of risk that have affected funds historically. As a measure of volatility, we think that standard deviation is not misleading to investors.”

The CSA says that it carried out a thorough study of alternative measures before deciding to go with standard deviation as its mandated risk indicator. For example, it notes that it examined tail risk indicators, such as Value at Risk (VaR) and conditional VaR.

“Our analysis revealed that these tail risk measures had a high correlation with standard deviation,” the CSA says in its notice, adding that standard deviation only underestimates risk relative to VaR in “a small minority of instances” and that when it does, the funds “were typically already classified as medium to high or high risk.”

The CSA’s notice adds: “Considering the limits regarding data availability for funds and the amount of data required to calculate tail risk measures accurately and given the high correlation between these measures and standard deviation, we have concluded that standard deviation is the most appropriate risk indicator.”

Given that most fund managers already use a methodology that is based on standard deviation, the CSA says that it does not expect to see widespread changes to investment risk levels in Fund Facts as a result of the new requirements.

In addition, the CSA also published final amendments on Thursday that would require ETF providers to deliver ETF Facts to investors within two days of a purchase. These requirements would also come into effect on March 8, 2017, but the implementation of the requirements will be phased in.

To start, ETFs will be required to produce and file an ETF Facts document and make it available on its website as of Sept. 1, 2017, but dealer delivery obligations wouldn’t come into effect until Dec. 10, 2018.

“ETF Facts will help investors make more informed decisions about ETFs, and we encourage advisors and investors to use it as a tool in their conversations about a purchase decision,” Morisset says.

The requirement for ETFs to deliver ETF Facts documents aims to create a more consistent disclosure framework between mutual funds and ETFs — although a key difference is that mutual fund disclosure has to be provided on a pre-sale basis.

The CSA says in its notice that it “expects to consider the feasibility of requiring pre-sale delivery of the ETF Facts” as well, although it is not yet proposing. Furthermore, the CSA notes that any proposals to require pre-sale delivery would have to go through the usual consultation process.

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