Are there pitfalls in the CSA’s fund risk rating system?

An investor protection group has issued a warning for investors to be wary of CSA-recommended fund risk ratings

The CSA’s approach of disclosing risk in terms of a fund’s volatility has been called into question by investor advocacy group Kenmar Associates, which released a statement titled “Beware Fund Facts Rating.”

Under a risk classification methodology put in place by the CSA, an ETF or mutual fund should be graded according to volatility in the fund’s performance over a 10-year period. According to the group, just under 20% of mutual funds in Canada have 10 years of history, meaning that the risk for over 80% will be graded using a reference index rather than their actual performance.

The group also questioned the regulator’s five-category risk scale, which classifies funds based on the standard deviation of their monthly performance over a ten-year period:
Standard Deviation CSA Fund Facts Investment Risk Scale
0-6.0 Low
6.0-11.0 Low to Medium
11.0-16.0 Medium
16.0-20.0 Medium to High
>20.0 High
Based on this classification, the group says, a fund that has had an average monthly return of 6% for the past ten years with a standard deviation of 16% would have 95% of its returns falling between -26% and 38%, and still be classified under “Medium” risk; a fund with an SD of 11% would have 99.7% of returns falling between -27% and 39%.

“The range is very large and near useless in making an informed investment decision,” said the group. They also pointed out that a 10-year SD will remain relatively stable year-to-year, meaning that the risk rating will remain the same even if market conditions and valuations actually warrant a different risk rating for a fund.

Kenmar Associates also questioned the reasoning behind several aspects of the risk rating system, including the fact that retail investors think of “risk” as the chance of losing money rather than volatility in fund performance, which makes the use of the term uninformative; the system is to be used for structured products such as leveraged ETFs; and certain investors may misconstrue a “Medium” risk-rated product to be suitable for those with medium risk tolerance, which is not the case since risk ratings do not equate with KYC risk tolerance.

“For this reason, we suggest referring to the simplified prospectus for details of the actual risks of the fund and talking to your fund salesperson before making a purchase,” the group said.

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