On December 10, 2015, the Canadian Securities Administrators (CSA) published for comment proposed amendments as part of stage 3 of the point of sale disclosure project mandating fund managers to use a standardized risk classification methodology (Proposed Methodology) when determining the investment risk level of conventional mutual funds and exchange-traded funds (ETFs) for disclosure in the Fund Facts document (Fund Facts), as required under Form 81-101F3 Contents of Fund Fact Document and the proposed ETF Facts document (ETF Facts), as required under proposed Form 41-101F4 Information Required in an ETF Facts Document, (together, the 2015 Proposal).
Currently, the Fund Facts require a mutual fund to provide its risk level on a five-category scale (ranging from low to high) using a risk classification methodology selected at the manager's discretion. No risk level or ratings are currently required by an ETF in the equivalent ETF summary disclosure documents (to be replaced by ETF Facts upon the coming into force of amendments to implement Form 41-101F4).
In December 2013, an initial draft of a standard risk classification methodology was published by the CSA in CSA Notice 81-324 and Request for Comment Proposed CSA Mutual Fund Risk Classification Methodology for Use in Fund Facts (the Initial 2013 Proposal). The Initial 2013 Proposal was developed in response to stakeholder feedback suggesting that a standardized risk classification methodology proposed by the CSA would be more useful to investors, as it would provide a consistent and comparable basis for measuring the risk levels of different mutual funds. The key objectives, as set out in the Initial 2013 Proposal, driving the construction of the Proposed Methodology are the following factors:
- Be a uniform methodology applicable to all investment funds
- Be easy to understand by all market participants
- Be meaningful and allow for easy comparison across investment funds
- Be difficult to manipulate for someone's benefit (i.e. minimize subjectivity or any form of discretionary risk assessment)
- Be relatively simple and cost effective for fund managers to implement
- Enable easy and effective regulatory supervision
- As much as possible, be a stable indicator of risk while fairly reflecting market cycles and broad market fluctuations
The CSA continues to believe that a standardized risk classification methodology will provide for greater transparency and consistency, and enable investors to more easily evaluate and compare the investment risk levels of mutual funds and ETFs. The 2015 Proposal is intended to allow investors to make more informed investment decisions by providing them with transparent and consistent information about the risk levels of mutual funds and ETFs in a language that they can easily understand.
2015 PROPOSED METHODOLOGY
The 2015 Proposal amended certain elements of the Initial 2013 Proposal to be applied in determining the investment risk level of mutual funds and ETFs, as set out in the following table:
|Initial 2013 Proposal||2015 Proposal|
|Risk Indicator||Standard Deviation||Standard Deviation|
|Application Mutual Funds||Mutual Funds||Mutual Funds and ETFs|
|Performance Period||10-year (annualized)||10-year (annualized)|
|Use of a Reference Index*||Yes||Yes|
|Data used||Monthly total return||Monthly total return|
|Risk Level Scale||Six category scale (low to very high)||Five category scale (low to high)|
|Fund Series/Class Used for Calculation||Oldest Fund series/class||Oldest Fund series/class|
|Frequency of Risk Classification Assessment||Monthly||Upon filing of a Fund Fact or ETF Fact (at least annually)|
|Record Keeping||10 years||Seven year|
*Monthly total return of a reference index should be used as a proxy to impute missing return data of a fund that does not have a 10 year track record.
**Manager permitted to use qualitative factors to re-classify an investment fund at a higher risk level only.
Standard deviation is a measure of how returns vary over time from the average return, and is intended to measure the volatility of investment returns (i.e. how spread out the returns are from their average, on average).
In selecting standard deviation as the Proposed Methodology, the CSA considered the risk classification methodology developed by the Investment Funds Institute of Canada (IFIC) and also the methodology used by other international regulators, including the Committee of European Securities Regulators (now the European Securities and Markets Authority, ESMA). In addition to standard deviation, which is used by both IFIC and ESMA, the CSA also considered 15 other risk indicators grouped into five categories:
- Overall volatility risk measures
- Tail-related risk measures
- Relative volatility measures
- Risk adjusted return measures
- Relative risk adjusted return measures
Following a review of each of the foregoing risk indicators, data pertaining to mutual funds available in Canada from 1985 to 2013, and feedback from the industry, the CSA found that there were relatively few cases where alternative risk indicators signaled a higher risk rating than that indicated by standard deviation. As a result, the CSA confirmed standard deviation as the most suitable risk indicator for the following reasons, among others:
- Its calculation is well known and established
- Its calculation is simple and does not require sophisticated skills or software
- It provides a consistent risk evaluation for a broad range of mutual funds
- It provides relatively stable but meaningful evaluation of risk when coupled with an appropriate historical period
- It is already broadly used in the industry
- It is available from third-party data providers (i.e. provides a simple and effective source of data for oversight purposes both by regulators, market participants and investors)
- The implementation costs are expected to be minimal
While the mathematical calculation of standard deviation seems difficult to some, the plain language description of volatility and suitability in the Fund Facts and ETF Facts, are intended to assist novice investors in making informed investment decisions.
Application to Investment Funds
In addition to Fund Facts, the 2015 Proposal extends its application of the Proposed Methodology to the proposed ETF Facts. This is consistent with the CSA's criteria and key objectives of the Initial 2013 Proposal to achieve a uniform methodology applicable to all investment funds, and to be meaningful and allow for easy comparison across investment funds.
The CSA did note that alternative funds, closed-end funds and structured products are not currently required to produce an equivalent summary document of the Fund Facts or ETF Facts, and accordingly, will not be subject to the Proposed Methodology or be required to determine their risk level. The CSA left open the possibility that if the disclosure requirements for these non-mutual fund products should change in the future, the CSA may consider the application of the Proposed Methodology to these products at such time.
The 2015 Proposal reaffirms the CSA's view that the use of an investment fund's 10-year performance return is preferable to the use of either shorter time periods (for example, three, five or seven years) or longer time periods (for example, 15, 20 or 25 years). The 10-year performance period is intended to strike a reasonable balance between indicator stability and the availability of data.
Although market reaction to the 10-year performance period based on the Initial 2013 Proposal varied widely among industry participants, the CSA noted that the results of standard deviation for shorter periods caused frequent risk band changes, whereas standard deviation calculations were more stable indicators of risk for longer time periods.
Use of a Reference Index
The CSA has reaffirmed the use of a reference index to impute missing data for calculating the standard deviation for funds that do not have the requisite 10-year performance history. This is achieved by allowing managers to add the monthly returns of a reference index selected by the manager to the available monthly returns of the fund. The returns of a reference index are expected to be correlated to the returns of the fund, rather than replicate returns of the fund exactly. As such, the CSA expect that there are a sufficient number of reference indexes available in the market that can serve as a proxy for the risk profile of various investment funds, including actively managed funds.
The Initial 2013 Proposal contained a list of criteria for an index to be considered acceptable as a reference index, as well as a list of reference index principles. While the list of criteria has been removed in the 2015 Proposal (including the requirements that the reference index must be widely recognized and publicly available), the reference index principles have been substantially preserved. Accordingly, a reference index should meet the following principles:
- Is made up of one or a composite of several market indices that best reflect the returns and volatility of the mutual fund and the portfolio of the mutual fund
- Has returns highly correlated to the returns of the mutual fund
- Contains a high proportion of the securities represented in the mutual fund's portfolio with similar portfolio allocations
- Has a historical systemic risk profile highly similar to the mutual fund
- Reflects the market sectors in which the mutual fund is investing
- Has security allocations that represent invested position sizes on a similar pro rata basis to the mutual fund's total assets
- Is denominated, in or converted into, the same currency as the mutual fund's reported net asset value
- Has its returns computed on the same basis (e.g., total return, net of withholding taxes, etc.) as the mutual fund's returns
- Is based on an index or indices that are each administered by an organization that is not affiliated with the mutual fund, its manager, portfolio manager or principal distributor, unless the index is widely recognized and used
- Is based on an index or indices that have each been adjusted by its index provider to include the reinvestment of all income and capital gains distributions in additional securities of the mutual fund
Under the 2015 Proposal, a fund must disclose in the prospectus a brief description of the reference index (including the use of blended indices, if any), and if the reference index is changed, details of the timing and reason for the change. The CSA notes that the same index used in a management report of fund performance may be used to determine a fund's risk level if the index reflects the risk profile of the fund and qualifies as for an acceptable reference index. The CSA also notes that where CSA staff has questions regarding the appropriateness of a reference index, the fund may be the subject of a continuous disclosure review in the future.
Keeping in line with the Initial 2013 Proposal, the Proposed Methodology uses a mutual fund's monthly returns to calculate standard deviation, which is consistent with current industry's practice.
Risk Level Scale
Instead of introducing a six-category risk level scale as recommended by the Initial 2013 Proposal, the 2015 Proposal maintains the five-category risk level scale, ranging from low to high that is currently prescribed in the Fund Facts and proposed ETF Facts. In response to stakeholder feedback, the standard deviation ranges from the 2013 Proposal have been aligned to mirror the standard deviation ranges in the investment fund risk classification methodology developed by IFIC, which is currently followed by a majority of industry participants.
The six-category risk level scale was a significant industry-wide concern as it was thought to lead to a large number of investment funds being re-classified into a higher investment risk level without any associated change in operations, objectives or risks. Many industry participants noted that the "very high' investment risk level was unnecessary, inconsistent with the existing symmetry with the know-your-client (KYC) five category risk tolerance levels, and that the new nomenclature would potentially add to investor confusion and industry disruption. By reverting back to a five-category risk level scale, the 2015 Proposal preserves the current risk scale that was initially developed by the CSA during the advancement of the Fund Facts regime in 2011.
One of the objectives of the Proposed Methodology is to minimize subjectivity or any other form of discretionary risk assessment. This is achieved in the Initial 2013 Proposal by prohibiting managers from incorporating qualitative factors into their risk assessment, which may otherwise result in misleading or biased risk ratings and defeat the goal of comparability and transparency. However, based on industry feedback, the CSA also recognizes that circumstances may give rise to the need for consideration of qualitative factors in determining appropriate risk levels.
To balance the risks associated with allowing managers to utilize discretion, the approach in the 2015 Proposal now permits managers to use discretion and to classify an investment fund at a higher risk level based on qualitative factors, but not to a lower risk level. As such, the risk level established by quantitative metrics to determine standard deviation is intended to, at a minimum, set the floor for a fund's risk ranking.
Fund Series/Class Used for Calculation
Given that the variance of standard deviation is relatively minor across series or classes of securities of the same investment fund, the 2015 Proposal only requires managers to use the returns of the oldest series or class of securities of a fund as the basis for calculation. The 2015 Proposal does not require funds to calculate the risk level for each series or class, unless any such series or class carries an attribute that could otherwise result in a different investment risk level than that of the fund (such as a particular currency hedged series or class of an investment fund, which may have a material impact on performance returns relative to other series or classes of the fund). In such instances, the risk level should be determined for that particular series or class of securities as well.
Frequency of Risk Classification Assessment
The Initial 2013 Proposal set out a process for monitoring risk categorizations on a monthly basis. In response to industry feedback suggesting that monthly monitoring would be burdensome on investment funds and could result in frequent short-term reclassifications, among other things, the 2015 Proposal now requires determining the risk level of an investment fund upon the filing of a Fund Facts or ETF Facts, and, in any case, at least annually. The CSA notes that this is the minimum requirement and that managers should be encouraged to reassess more frequently, as may be appropriate.
The 2015 Proposal has removed the requirement to maintain records for a 10-year period when using the Proposed Methodology to determine the risk level of a fund. Instead, consistent with the existing requirement in securities legislation to maintain records for a period of seven years from the date that the record was created, managers will be required to maintain records for a seven-year period.
New requirements to the Proposed Methodology have also been added to the 2015 Proposal regarding how to calculate standard deviation for a fund that has undertaken a reorganization or transfer of assets, or where there has been a change to the fundamental investment objectives of a fund. In these instances, the Proposed Methodology requires standard deviation to be calculated using the monthly "return on investment" of the continuing fund, or commencing from the date of the change in investment objectives, as applicable.
TRANSITION AND REQUEST FOR COMMENTS
Subject to the rule approval process, it is anticipated that the final rules implementing the 2015 Proposal will be published in the Fall of 2016 and will come into force three months later, upon which the investment risk level of mutual funds and ETFs must be determined using the Proposed Methodology for each filing of a Fund Fact or ETF Fact.
CSA requests comments on the 2015 Proposal on or before March 9, 2016.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.