Are low-risk funds really low risk?

Ruth Saldanha: Over the past couple of months, several mutual fund and ETF providers have changed their risk ratings, usually on the lower side. As a result, even equity funds could have low or low to medium fund ratings. In this scenario, how should you decide if the fund matches your risk level? Mark Noble, Vice President of ETFs Strategy at Horizons, is here with us to share his point of view.

Mark, thank you for being here today.

Mark Noble: Great to be here.

Saldanha: First up, why are providers changing the risk ratings right now?

Noble: Well, there's a regulatory reason why they're changing. But before we get into that, we need to ask the question, "What is a risky investment?" And the answer is, "We don't know." And it's one of those things where if I was to go into a group of portfolio managers and ask what is a risky investment, you have a litany of answers, because people conceive and perceive risk differently. So, the regulators from a fund disclosure perspective, obviously, want investors to be informed, but they're trying their best to create a cookie cutter solution to address risk. And so, what has been agreed upon by the regulators, and what's enforced is that risk ratings are determined by using a 10-year rolling standard deviation, so standard deviation being how it goes up and down, over the past 10 years. And if you have launched a new fund, for example, you'd use a benchmark proxy for what you are using, and then would provide that risk rating.

Does it work? We don't know. But what's happened is that 2008-2009, you had the biggest financial crisis in 70 years, and over the last year, we've now removed that period from outside this 10-year tracking window. So, pretty much every investment solution is now being able to downgrade its risk ratings. If we had a big bump on a go-forward basis, we might see those risk ratings go up, but you're moving this huge outlier amount of risk. And since sort of 2010, we've had almost a goldilocks market environment until last year where risk and volatility has been very low. So, if I just use this quantitative example of this rolling 10-year standard deviation, almost every type of asset class would likely be rated low to medium risk.

Saldanha: So, then how should investors decide how to match their risk level with what they buy?

Noble: And this is where education really comes into place. I mean, are technology equities low risk? And the answer is probably no, right? But if I look at 10-year rolling standard deviation, maybe they looked like they would be low risk. So, there needs to be an understanding, I think, for investors that risk and return are two things to really understand. If you're getting double-digit returns in certain asset classes, there's usually a correlation to that being higher risk. And that typically exists with investing that the higher return you generate, it's usually, there is some risk. There's obviously anomalies to that. So, there has to be, I don't want to say horse sense, but kind of is the practical common sense that certain asset classes, particularly growth equities, they don't pay a dividend, or new sectors like marijuana equities, or looking at things like high-yield bonds relative to investment-grade bonds, that those should have higher risks that built into them is the idea there's a higher amount of entrepreneurial and capital at risk. And therefore, regardless of what the performance has been in the past, and there's a reason we have that disclaimer that says, past performance is not indicative of future returns, there needs to be and understanding that there's a lot more future risk there.

But yeah, if you just look at the risk ratings, it may not provide the snapshot you're hoping, which again, requires a little bit more education, working with an advisor, reading Morningstar.ca and the analyst reports really understand is, what am I owning here and what are some of the challenges that could face on a go-forward basis.

Saldanha: Things get even more tricky when it comes to fixed income. So, from a fixed income standpoint, especially for funds that are chasing higher yield, how do you decide what is high risk and what is low risk?

Noble: Yeah. That one is actually a little bit easier for me, because really what you can look at with fixed income is sort of a risk-free rate of return and your risk-free rate of return is U.S. treasuries. So, if you're getting 2% on or you know, Canadian 5-year you're getting like 1.5%, that's your risk-free rate of return. So, if something is yielding 6% that is not a low-risk fixed income investment, okay? It may be perfectly great investment, right? That may be a company that's mispriced, and that's high yield and paying 6%, it's the deal. But it's been determined by credit valuations of the market that it needs to pay 400 basis points above the risk-free rate. And that should be sort of where you're looking at.

So, if you want to understand lower risk on fixed income, then you should be looking at what are the rates on government bonds, and every increment of 100 to 200 basis point more, you're taking on more risk. That's a little bit easier. Equities gets a lot harder, obviously. But the equity risk in general should just be sort of viewed as higher risk than most fixed income, the exception being sort of high-yield bonds and preferred shares, which could have volatility similar to equities.

Saldanha: Thank you so much for joining us today, Mark.

Noble: My pleasure.

Saldanha: For Morningstar, I'm Ruth Saldanha.