Canada's unreliable risk ratings

A downward shift in fund risk ratings now that the market crash of '08 is out of the picture demonstrates the limitations of the CSA system, says Morningstar's Paul Kaplan

Paul D. Kaplan 6 September, 2019 | 1:55AM

 

 

Paul Kaplan: I'm Paul Kaplan, Director of Research at Morningstar Canada. Risk is an important consideration when making any investment including in mutual funds. To help investors understand the risk of investing in funds, the CSA introduced its mutual fund risk classification system.

How well has this system served investors? Under the CSA methodology, a fund's risk classification is based on the historical volatility of its returns over the past 120 months, volatility being measured by annualized standard deviation of returns. The preliminary rating is set by seeing where the standard deviation falls on this chart. Fund managers can override this assignment. The ranges of standard deviation that determine risk classification are fixed over time. So, as the 120-month window of historical returns moves over time, so can risk classifications. In recent months, this has led to a large number of funds being reclassified when the monthly returns on funds over the period of the market crash of September 2008 through March 2009 rolled out of the 120-month window used to measure the risk of funds. To see what happened, they obtain monthly returns on the oldest share classes of Canadian funds priced in Canadian dollars over the 13-year period beginning August 2008 to July 2019. There were just over 1,200 funds that have that full 13-year return history.

I calculated the standard deviation of each fund over the 120 months ending in July 2016 and over the 120 months ending in July 2019. I 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.

I also looked at the transitions of funds between July 2016 and July 2019 as shown on this chart. 38% of funds that were low to medium risk in 2016 became low risk. 61% of medium risk funds became low to medium risk. And almost 90% of medium to high risk fund became medium risk. This shift in risk classifications demonstrates the limitations of the CSA risk classification system. Since the risk classifications of so many funds can change over the passage of time without any changes in their strategies, they are not a reliable way for investors to assess the risks of funds.

About Author

Paul D. Kaplan