Communicating risk

But what regulators have not resolved is how fund firms should be reporting investment risk to clients in these documents – an ongoing challenge that has both investor advocates and some industry players scratching their heads.

In response to criticism from investor advocates, the Canadian Securities Administrators (CSA) announced in 2013 that it intends to require issuing firms to use a standardized methodology for assessing and disclosing how risky individual funds are in their Fund Facts. That idea has broad support, but choosing the right methodology is proving trickier.

The latest version of the CSA proposal was published in December 2015. Once again, the CSA contemplates using standard deviation as the basic metric for assessing risk. Under the CSA’s proposal, issuers would be required to use the standard deviation of funds’ returns over the previous 10 years as the basic way to define risk; then slot funds into one of five categories (ranging from low- to high-risk) based on that statistic to illustrate the riskiness of a fund to investors.

Critics contend that standard deviation is a poor way to define investment risk. And, unlike many controversial issues in the investment business, that belief is something that certain industry players and investor advocates actually agree on.

Not appropriate

For example, Toronto-based Invesco Canada Ltd.‘s comment on the latest round of CSA proposals points out: “Virtually every investor who submitted comments, virtually every ‘investor advocate’ and even some of our industry colleagues [agree with Invesco’s contention that] standard deviation is not an appropriate measure of risk for a retail investor.”

The basic criticism of relying on standard deviation to define risk is twofold:

First, standard deviation measures the volatility of returns only, and ignores many other factors that impose risk on an investment, such as liquidity risk, credit risk and interest rate risk, to name a few.

Second, standard deviation doesn’t get at the heart of the concept of risk for average retail investors – that is, the genuine prospect of losing their money. Rather, standard deviation, by itself, simply highlights the extent to which the value of an investment may fluctuate over time.

Disclosure

“There is broad agreement that investment risk is not confined or limited to volatility risk,” states the comment from Toronto-based Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada).

And so, FAIR Canada’s comment argues that Fund Facts shouldn’t be limited to relying on volatility risk, either: “If it does, it will seriously limit the usefulness of [Fund Facts] for those who use and rely on it – investors and their advisors.” (The comment adds that using standard deviation may actually mislead investors and advisors.)

FAIR Canada’s comment notes that global regulators have developed principles that call for risk disclosure to retail investors to include all types of risks an investment faces, not just volatility, and recommends that the CSA give its proposals yet another rethink.

Invesco’s comment also calls on the regulators to reconsider.

The CSA has indicated that it is proposing standard deviation because the concept is widely used, it’s easy to calculate and implementation costs will be minimal, among other factors.

Moreover, if standard deviation doesn’t do the job, as its critics contend, what should regulators turn to as a mandatory, standardized risk measure that the average investor can understand?

Coming up with a sound alternative is no small challenge, states a comment from long-time industry analyst Dan Hallett, vice president and principal at HighView Asset Management Ltd. in Oakville, Ont.: “No single statistic can fully capture investment risk.” If regulators are going to try to boil down risk to a single statistic, Hallett’s comment continues, they should use “intuitive risk metrics.”

Specifically, Hallett recommends using “maximum drawdown and recovery time” as the best, simplest way to capture investment risk; those metrics indicate the furthest a fund’s units’ value has fallen, how long the drop took to play out and how long the fund’s net asset value took to recover from that decline.

Calculation periods

Hallett says that this method, which can be calculated using the same data that’s required to compute standard deviation, would be a more useful way of communicating risk to the average investor. And, he suggests, these calculations would be more stable than either the current approach to disclosing risk or the CSA’s proposed new standard method (the latter of which is impacted by the calculation period, and can result in a decline in reported risk simply as time marches on).

For example, Hallett’s comment points out, the impact of the global financial crisis soon will disappear from calculations that look back 10 years, the period that the CSA is proposing: “In two short years, the worst bear market of this generation will disappear from the trailing 10-year record. And if another bear market has not occurred in that time, the 2007-09 financial crisis will slip out of the 10-year time frame and standard deviations are likely to fall.”

As a result, if the CSA adopts its proposed methodology, risk ratings also are likely drop for many investment funds in the next couple of years – leaving ordinary investors possibly underestimating the risks they are taking.

Both the industry and investor advocates are likely to lament a missed opportunity.

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