Can investors still trust risk ratings?

After 10-years of strong growth – as of the end of the second quarter of 2019, the S&P 500 is up 13.67% annualized over 10-years in Canadian dollar terms, while the S&P/TSX Composite is up 7.79% in the same time frame – investors are waiting the other shoe to drop and some have decided to set a course for fixed income in the absence of accurate risk information.   

A dangerous omission

“2008-09 has entirely gone from newer fund fact documents, and now lots of equity funds have low-to-medium risk ratings. That is an issue, because investors are underprepared for reality,” points out Dan Hallett, VP and Principal at HighView Financial Group.

Investors may be familiar with the current definition of risk, which The Ontario Securities Commission’s website getsmarteraboutmoney.ca defines as, “the possibility of an investment’s actual return differing from its expected return and the potential to lose some or all of the money you have invested.”

And there are various types of risk, like investment risks, economic risks, currency risks, interest rate risk, market risks, and others. As an investor, your willingness to handle risk determines your risk tolerance, and therefore your portfolio. For example, if you are able to handle large swings in the value of your investments, you have a high-risk capacity, and could consider risker asset classes, such as equity.

But it’s difficult to make this assessment when mutual funds and exchange traded funds (ETFs) in Canada use standard deviation to measure investment risk levels, usually over a three, five or a 10-year timeframe, all of which are beyond the threshold of the last recession. Based on this, investors are left with a risk level plotted along a five-point scale from low to high – which may not mean much anymore.

Standard deviation still true?

Morningstar has always held that standard deviation does not reflect investors' perception of investment risk. “Standard deviation measures the spread of returns around a mean value. Therefore, any value above the mean (positive returns) carries exactly the same weight as a value below the mean (downside risk). As a result, standard deviation punishes positive performance,” points out Wendy Stein, senior product manager at Morningstar.

Paul Hamilton, Vice President, Managed Assets, Beutel, Goodman & Company, agrees. “In our view, simply rating the risk of funds by looking at the last 10 years of volatility does not capture the full investor experience of owning a fund. The dropping off of 2008’s poor equity market returns from the rolling 10–year investor experience results in the omission of an important time period for assessing the risk and suitability of a fund.” He points out that the method is like judging how smooth your transcontinental flight to Europe was without taking into consideration the panic-inducing three minutes when you hit severe turbulence.

“Investors need to be cognizant that we’ve been enjoying a 10+ year bull market without a major and sustained correction. Therefore 10-year standard deviation and the Fund Facts risk ratings that are derived by the calculation don’t tell the whole story,” Hamilton points out.

Moreover, he notes that the current methodology and regulations have created a grey area that can cause potential conflicts of interest. “A number of investment managers are now in a position to adjust their risk ratings lower, which may help their respective funds appear more attractive to investors. This is potentially incentivizing firms to post the lowest allowable rating of their funds, as those managers who opt to maintain a risk rating they believe truly reflects the investor experience may be disadvantaged from a sales perspective versus their peers,” he says.

Morningstar Direct data shows that over 700 Canadian Equity funds, many with majority of their portfolio in equity, have a risk level of “Medium”, while around 65 have a risk level of low-to-medium.

“How can a 100% equity fund be low-to-medium risk?” Hallett asks.

How indeed.

Morningstar Canada's director of research Paul Kaplan calculated the standard deviation of each fund over the 120 months ending in July 2016 and over the 120 months ending in July 2019. He found that there was a massive downward shift in the standard deviations of funds, which would lead to a corresponding downward shift in risk categories in the absence of overrides.

As the chart shows, low risk funds went from being 20% of the sample up to 30%. Low to medium risk funds rose from 27% to 41% of the sample and medium risk funds fell from 39% to 24% of the sample.

What should you do?

Having said that, in these circumstances, how should an investor decide where to invest? Hallett suggests a simple formula. “Investors should assume that anything that is purely stocks or equity WILL drop 40% to 50% and will stay underwater for two or three years. It may happen once every decade, but you will see a significant drop, and you should be prepared to face it,” he says.

Baking in the losses may be a more accurate way of assessing risk today.  

Hamilton points out that there is no one-size-fits-all answer to this question. “For example, volatility is a much more important consideration for investors closer to retirement, as they need to preserve the immediate value of their capital to fund their retirement. Any losses – even if temporary – can be damaging. For these investors, the short-term standard deviation is an important metric to consider. For long-term investors, volatility should matter much less, as avoiding the permanent loss of capital over the long term is much more important,” he says.

He believes it is key that investors understand how a particular fund manager mitigates risk as a function of their investment discipline. “Important metrics investors should consider are calendar-year returns versus the benchmark, particularly in down years such as during the financial crisis in 2008 or the tech bubble in 2001, and the maximum drawdown for a fund compared with the category and index over various time periods,” Hamilton adds.

What about fixed income?

“Since we are likely close to the peak of the current economic cycle, we believe it’s important for investors to understand the risk inherent in their fixed-income portfolios. There are two primary risks when it comes to fixed income – credit risk and duration risk,” Hamilton says.

Duration risk refers to the price sensitivity of a bond in the event of a change in interest rates. Credit risk is the risk that the bond’s price deteriorates due to a significant weakening in a company’s fundamentals, or in the worst-case scenario, that the issuer defaults on its debt.

“Investors should compare the fund’s credit-quality characteristics with the category average and know what percentage, if any, the fund can invest in non-investment-grade debt (high yield),” Hamilton says.

Hallett notes that in the wake of 2008, there has been a reach for yield, with products introduced that offer significantly higher yield than government bonds. “There is definitely risk involved, even if the risk is not clear in the numbers. Investors should note that it is prudent to look for where the risk is. There could be more downside,” he warns.

For duration risk, Hamilton points to a handy “rule of thumb” that the duration, which is measured in years, approximates the price change of a bond portfolio given a 1% change in interest rates. For example, if a bond fund’s duration is 8 years, this implies that a 1% increase in interest rates will cause the fund’s price to fall by approximately 8% and a 1% decrease in interest rates would result in a gain of approximately 8%.