Pitfalls seen for anticipated ETF rating system

One analyst explains why risk ratings to be used in ETF facts may not protect investors

Pitfalls seen for anticipated ETF rating system
An ETF analog of the Fund Facts used for mutual funds, ETF Facts, is going to be required from dealers starting September. Both documents include a five-point risk rating section, ranging from “low” to “high,” that should inform investors of how risky it is to invest in a product. However, the effectiveness of the system created by the CSA for rating ETFs has been called into question.

“Product sponsors will calculate each fund’s standard deviation (SD)… and map the number to one of the five risk labels,” said Dan Hallett of HighView Financial Group in a piece for the Globe and Mail. “Unfortunately, this simple-sounding method doesn’t tell investors anything about how much they could lose or how long they should hold a fund to minimize the chance of loss.”

Hallett related how in 2008, Fund Facts typically rated stock funds as “medium risk” even though past bear markets that had cut stocks’ value in half were likely to recur. Sixteen months later, stock markets around the world declined by 40% to 60%, and investors who relied on the “medium risk” label were caught unaware.

“[O]ne could argue that risk increases as stock and bond prices keep rising,” he went on. “We’re nearly eight years into one of the longest bull markets in history for stocks and bonds.” However, tracking risk rating changes for nearly 100 unique mutual funds and ETFs over the past two years, Hallett observed risk rating reductions for 77% of the funds.

He cited the case of MD American Growth. “From August 2000 through March 2003, this fund lost 55 per cent of its value,” he said, going on to say that it rose less than 20% in the following four years, after which the financial crisis slashed another 41% off of its value. All in all, the fund suffered a peak-to-bottom loss of 68%, and as of Nov. 30 was still a few percentage points below its August 2000 peak.

“This past May, its risk rating was dropped from ‘medium-to-high’ to ‘medium,’” Hallett said. “The CSA’s new risk rating method would keep this firmly in the medium risk bucket despite losing more than two-thirds of its value and only now inching back toward its peak from more than 16 years ago.

“As professionals working directly with – and held accountable to – our clients, we take the measurement and communication of risk very seriously,” he said. “While I don’t doubt regulators’ intent, this risk rating method makes no sense to me.”

Related stories:
Final amendments on risk ratings published
Are there pitfalls in the CSA’s fund risk rating system?