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Risk may be top of mind for many people these days – with public health, the economy and financial markets challenged. Given my focus on due diligence, I think a lot about where risk lies in waiting, how to measure it and how to communicate it to readers and clients.

If you are invested in an investment fund – that is, a mutual or exchange-traded fund – you have likely seen a document called Fund Facts or ETF Facts. These are regulatory documents that summarize each fund’s key attributes. Perhaps the most controversial component of the documents is the risk rating, which was standardized a few years ago.

Risk is assessed in two steps. The fund’s sponsor first calculates each fund’s 10-year standard deviation (SD) – a statistical measure of how wildly a fund’s monthly returns bounce around its average monthly return over the 10 years. The SD figure is then annualized and mapped to a five-point risk scale ranging from “low” to “high.” That risk label appears in each product’s Fund Facts or ETF Facts disclosure document. As far back as 2007 (when Fund Facts was first proposed), I was a vocal critic of this method because it doesn’t inform investors, in my view.

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The idea of summarizing an investment in a digestible document is a great idea. But Fund Facts and ETF Facts have never lived up to their full potential when it comes to communicating risk. A few years ago, regulators codified a standard method to assess and label each fund’s risk. In my March 2016 letter to regulators, I argued against their chosen hard-to-understand statistical calculation and arbitrary mapping to risk labels. Rather, I proposed a more intuitive approach – i.e. simply showing a fund’s past bear-market losses.

I reasoned that investors would not be able to meaningfully translate arbitrary labels such as “low,” “medium” and “high” into probable outcomes. I also feared that the preferred method would cause the level of risk in the rating to drop, which would then set investors up for a rude awakening when the next bear market arrived. A year later, in this January 2017 blog post, I confirmed that this was exactly what was happening.

Now that 2020 has served up the first bear market since the financial crisis, we have a real-time test of risk ratings found in Fund Facts and ETF Facts. Thank you to my friends at Fundata Canada Inc. for providing me with the raw data to see just how well the risk rating labels aligned with this year’s bear market losses. (Brian Bridger, Fundata’s vice-president of analytics & data, also published a good article on this topic.)

The table below shows losses for the months of February and March 2020 combined, with highest, lowest and average returns broken down by risk rating. The table also features a breakdown of funds by severity of losses for each risk rating.

Risk rating

This table shows the range of mostly negative returns (including average returns) for each risk rating category. For example, the average return for low risk funds was minus 5.4%, with a high (gain) of 5.6% and a low of minus 24.8%. Similarly, the bottom part of the table breaks down each risk category by severity of losses. For example, 51.3% of low risk funds lost more than 5% but not as much as 15%.

Risk Rating →LowLow to MediumMediumMedium to HighHigh
-5% < Return < 0%35.2%5.1%0.7%2.1%5.8%
-15% < Return < -5%51.3%57.5%29.4%30.7%13.2%
-25% < Return < -15%1.6%32.2%57.8%35.3%28.1%
Return < -25%0.0%3.1%11.8%27.7%49.6%

Monthly returns and risk rating data provided by Fundata Canada Inc. Calculations by HighView Financial Group. 

Table excludes alternatives categories and leveraged & inverse ETFs

Risk can be complex and multi-faceted, which is why it’s problematic to use one measure to define and capture total potential risk. That’s also why you see such wide ranges and steep losses for funds in each risk-rating category; even those that imply safety and stability. Most funds rated as “low risk” lost between 5 and 15 per cent in two months. The loss of nearly 25 per cent for one “low risk” fund jumps off the table. I don’t know anyone who equates “low risk” with double-digit losses, let alone losing one-quarter of an investment’s value.

Among the many “low risk” funds that lost 10 per cent or more were high-yield bond funds and balanced funds with plenty of stock-market exposure. And the “low risk” fund with the dubious honour of losing 24.8 per cent of its value? That is an income-oriented global balanced fund with more than 60 per cent of its holdings in stocks, and fixed-income focused on riskier high-yield bonds. Stocks have historically lost 30 to 50 per cent every decade or so for the last 140 years. The mandatory risk-rating methodology ignores what each fund holds (that is, stocks or bonds), which is how you end up with heavy stock-market exposure in the lowest risk categories.

The “low to medium risk” category contains an awful lot of funds holding nothing but stocks – which is nonsensical. More than 35 per cent of the 1,200 funds in this category lost more than 15 per cent, of which 38 per cent saw declines of more than 20 per cent. Ouch!

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While imperfect, I still believe that simply showing past bear-market losses (and length of recoveries) better informs investors about risk. But all of this misses a larger point. The vast majority of investors build portfolios with multiple investment funds.

The purpose of an investment portfolio is to achieve its owner’s goals. And that can only be successfully achieved if a portfolio is a fit from a risk perspective. Providing piecemeal risk ratings by product leaves investors in the dark about the level of risk embedded at the total portfolio level. That’s why diligent advisers provide meaningful portfolio risk metrics – before asking clients to commit to a proposed portfolio.

Dan Hallett is vice-president and principal of Highview Financial Group.

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