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Funds play the risk-rating change game
10/21/2018 9:16:31 AM
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The Analyst’s Desk
Informative and authoritative articles on the world of investment funds from Fundata’s Investment Analytics and Research team.



By Brian Bridger  | Monday, January 22, 2018


 

A SPECIAL REPORT FROM



The CSA guidelines for calculating investment risk ratings became mandatory for new filings as of Sept. 1 last year. However, many fund companies had already begun voluntarily using the new methodology since the rules were finalized at the end of 2016. So while not all funds have adopted the new methodology, we have a fairly large sample size to look at, and as I predicted in previous articles, the results are not surprising. The risk-rating changes started coming thick and fast, and will continue through 2018. Here’s why investors should take note.

A total of 286 funds had risk rating changes in 2017. This amounts to 10% of all funds that were active at the end of 2016 and is a fourfold increase year over year. Ratings decreases (216), have far outpaced ratings increases (70). Granted, while it has not quite been the 97% clip that I said was possible, a 3-to-1 ratio is still awfully high. And as I mentioned, the bulk of the changes would likely start to occur in late 2018. As we wait for the rest of the dominos to fall, let’s take a look at some of the changes thus far.

I have intentionally left out the actual fund names, the main reason being that this article only covers funds that have changed ratings, and it would be unfair to call out these funds while not also mentioning the funds with similar risk ratings that did not necessarily have a change in 2017.

A total of 70 funds increased their risk rating in 2017. Eight of these funds increased their prospectus risk by two rating levels, and in all of these cases, the funds moved to “High” risk from “Medium.” Three of these funds are commodity funds that hold either gold or silver bullion. Moving the risk rating up for these funds is somewhat obvious considering one of these funds (the only one with a 10-year history) has a 10-year annualized standard deviation (SD) of over 25%. Other notables in the group include a Natural Resource fund, a Global Equity fund with a 10-year SD of over 20%, and a U.S. Equity fund with a 7-year SD of 33%!

Of the remaining 62 funds that increased their prospectus risk rating by one level, the category that stands out is U.S. Equity. Nineteen funds had risk rating increases, with most ratings moving to “Medium to High” from “Medium.” While there is one fund that seems to have voluntarily increased its risk rating, most have done so because their 10-year SD is slightly over the “Medium to High” threshold of 16%. Yet most have a 9-year SD that is below the threshold. Therefore, if low volatility persists through 2018, many of these funds will be eligible to revert back to a “Medium” risk rating, which is something to keep an eye on later this year.



There were 216 funds that decreased their risk rating in 2017, and three of these managed to lower their rating by two levels. These include a Real Estate Equity fund, Emerging Markets Equity fund, and a U.S. Equity fund, and in all cases the rating changed to “Medium” from “High.”

The Emerging Markets Equity fund rating change is curious, considering even the last installment of IFIC’s Voluntary Guidelines for Fund Managers Regarding Fund Volatility Risk Classification (June 2017), suggested funds in this category be assigned a risk rating of “Medium to High.” Given that this fund only debuted in 2016, there is no way to validate the 10-year SD, and while the company attributes the change to the CSA methodology , there is no mention of the proxy used to backfill the 10-year history. However, if we use a standard benchmark such as the S&P DJ Emerging Markets TR Index (C$) or even the category average, the 10-year SD would indicate “Medium to High” risk.

The U.S. Equity fund is also interesting, as the fund is highly concentrated in the tech sector. The top four holdings account for close to 30% of the portfolio and include Facebook, Apple, Alphabet (Google), and Microsoft. And while the 10-year SD is technically under the “Medium to High” threshold (albeit just barely), the 20-year SD for this fund is over 22% and during the early 2000s tech bubble, suffered a maximum drawdown of 83%! Hardly the type of loss a “medium-risk” investor would expect.

Dubious rating changes

That leaves us with 213 funds that lowered their rating by just one level. There are examples from across almost every category, but there are some clear trends. There was a disproportionately large number of Canadian and Global Fixed Income Balanced funds that lowered their ratings. And in all cases, these funds moved down to “Low” risk, which is below the ratings suggested by the aforementioned IFIC methodology. Emerging Markets Equity and High Yield Fixed Income funds also account for a high percentage of the changes.

Overall, there were 32 equity funds that lowered their rating down to “Low to Medium,” a rating that the IFIC methodology has never suggested for any equity category. With markets at all-time highs and valuations stretched, do we really think equities are less risky than ever?

Now for a few of the more dubious changes. A Greater China Equity fund lowered its risk rating to “Medium to High” from “High” and cited the new CSA rules as justification for the change. However, its 10-year SD is over 22%, a historically low value for this fund and still well above the threshold for a “High” rating. Similarly, a Global Equity fund moved to “Low to Medium” from “Medium” despite having a SD in excess of the 11% threshold.

There are many other examples of risk rating that do not meet the eyeball test, however much the persistently low volatility in the market has depressed SD values. The big problem is that the longer this goes on, the more irrelevant the risk ratings become.

Brian Bridger, CFA, FRM, is Vice President, Analytics & Data at Fundata Canada Inc. and is a member of the Canadian Investment Funds Standards Committee.

Notes and Disclaimers

© 2018 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.

 
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