Lowering of PIMCO fund's risk rating illustrates need for reform

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I have written many times over the past several years about the shortcomings of the prevailing method of assessing and communicating risk to mutual fund investors. I felt strongly enough about this to make a personal submission to regulators to share my thoughts on this important issue. A recent change to one popular fund's risk rating simply confirms the weakness of the current risk rating method and the need for legislated meaningful risk measures.

The vast majority of fund companies in Canada use the risk rating guidelines designed by the Investment Funds Institute of Canada (IFIC). The paper describing the method in detail was not made public until recently when IFIC submitted its comments to regulators on this issue (starting on page 19 of IFIC's submission). A summary of IFIC's approach is to calculate 3– and 5-year standard deviations and applying the results to a five-point scale tied to descriptive labels – i.e. low, low-medium, medium, medium-high and high – used in prospectus and Fund Facts disclosure documents.

Fund companies don't have to use this method. But even if they do, they can exercise discretion to deviate from IFIC's guidance. While IFIC recommends documenting the rationale for deviating from the guideline, this is not a requirement. New funds can simply use the standard deviation of a benchmark or its category as a proxy. IFIC recommends reviewing all risk ratings annually.

PIMCO Canada Corp. recently lowered the risk rating of its popular PIMCO Monthly Income fund from 'low-medium' to 'low'. This likely resulted from the fund recently hitting its three year anniversary – allowing it to use its short but strong track record to calculate risk.

This flexible fixed income fund is an ideal mandate for PIMCO to flex its active management muscle. It's worked well so far, judging by the fund's strong performance and its fees are very competitive to boot. I haven't done due diligence on this product but there appears to be a lot to like. While I understand the IFIC method I don't understand how risk goes down after a string of strong returns in a period that has not seen even a mild bond bear market.

While there are no strict constraints, this fund has so far been exposed to higher credit risk. As of mid-2013, more than 60 per cent of the fund's holdings in debt and other obligations rated below BBB. See page 72 of the fund's June 2013 semi-annual report for this credit risk breakdown.

It uses a number of derivative instruments including currency and interest rate swaps. Aside from the counterparty risk this involves, there is the risk of being wrong. The fund ordinarily takes short positions – albeit modest ones – and uses credit default swaps (bets that companies will default). Finally, the portfolio is heavily traded. In its first 2.5 years, this fund's turnover has averaged 380 per cent annually – meaning that its dollar weighted average holding period for investments has so far been about as long as a university semester.

Any investment that has generated strong double-digit returns should not be considered 'low risk'. This misleads investors into thinking that low risk and high return is a reasonable expectation. More importantly, the rating doesn't adequately inform investors about the risks that lie ahead during the next credit market freeze or when the PIMCO managers show their humanity and get some of their bets wrong.

PIMCO is following the rules. But assessing this as a low risk fund simply shows the inadequacy of the status quo that so many fund companies have argued to maintain.

Dan Hallett, CFA, CFP, is director of asset management for HighView Financial Group and a contributor to thewealthsteward.com.