Advisors on the lookout for news on mutual funds may not find cause for alarm from recent risk-rating reductions announced by numerous providers. But one investor advocacy group is calling for caution as it questions the methodology used to determine such ratings.
“Under a risk classification methodology put in place by Canadian regulators, a mutual fund’s or ETF’s risk must be graded according to volatility … in the fund’s performance over a 10-year period,” wrote Kenmar Associates in a new investor alert. Investment funds — as well as seg funds — are rated on a five-point scale, from Low to High risk, with no narrative required to lay out the actual risks they are exposed to.
The alert highlighted how investor advocates and consumer groups have spent years asking regulators to not consider volatility alone in determining risk ratings to be used in fund facts. Before that approach was mandated by regulators, the use of return volatility as a measure of risk was espoused in guidelines developed by the Investment Funds Institute of Canada (IFIC). Defining risk based on that approach, Kenmar argued, did not consider risk as it related to investors’ actual priorities.
Things have gotten worse, the alert said, as the 2008 financial crisis drops off from fund companies’ 10-year calculations, leading to risk ratings that are “not only incomplete and inappropriate,” but also “misleading.” Citing Dan Hallett, vice president and principal with HighView Financial Group, Kenmar said that fund companies have lowered risk ratings on Canadian funds at least 274 times since March 2017.
“This includes what are widely considered to be higher-risk fund categories, such as emerging markets and commodity funds,” Kenmar said. “Falling risk ratings are now unduly putting many Equity funds in a Low-to-medium rating category, while several Balanced funds are being reclassified as ‘Low risk’. With stock markets near record highs and interest rates at record lows, you can be sure that real world investing risks are high.”
The alert also called attention to upward discretion extended to fund managers, which gave them the ability to ignore calculations of lower risk if they felt the results did not appropriately reflect actual risk. Since it is done on a voluntary basis, some managers may choose to downgrade even as their peers who have similar funds hold their original risk ratings, leading to inconsistencies that undermine attempts at comparison.
“Do not use the risk rating in Fund Facts for investment decision making or to compare funds,” Kenmar said, adding that even the Worst Three Months chart is questionable as it disregards bear-market data points.
“If you have been deceived by the rating and been sold unsuitable funds, your complaint may be denied because the dealer may argue they used the rating in good faith when making a recommendation to you,” the alert warned.
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