Canadian groups are proposing fund risk ratings

OTTAWA — Two approaches for assessing mutual fund and hedge fund risk are moving forward in Canada.
APR 23, 2007
By  Bloomberg
OTTAWA — Two approaches for assessing mutual fund and hedge fund risk are moving forward in Canada. The first, the Fund Volatility Risk Classification system, has been adopted by the board of the Investment Funds Institute of Canada, a Toronto-based national association of mutual fund management companies, retail distributors and associated legal, accounting and other professionals. The IFIC had not released the system by press time. Under the system, mutual funds are classified in one of six broad risk categories, ranging from very low risk to high risk, defined on the basis of the historical standard deviations of appropriate market benchmarks. The standard doesn’t apply to hedge funds.
The new guidelines have been “enthusiastically adopted by the industry,” Ralf Hensel, corporate secretary and director of policy and manager issues at the IFIC, said at a Montreal conference of the institute’s Quebec wing, Conseil des fonds d’investissement du Quebec. Compare and contrast A Feb. 22 draft of the proposed regulation noted that the recommendations were created “to help fund companies apply consistent fund volatility classification methodology and disclosure, and to assist dealers in comparing and assessing funds for their clients.” To ensure that mutual fund risk is defined and classified in a consistent fashion, the Canadian Securities Administrators adopted National Instrument 81-101 Mutual Fund Prospectus Disclosure, a regulation that requires risk to be disclosed in mutual fund prospectuses. The Canadian Securities Administrators is a Montreal-based organization of provincial securities regulators. An IFIC working group established a subcommittee to review various options for categorizing mutual fund volatility and to recommend a method for measuring and categorizing risk for various fund types. “There were two essential requirements for this categorization,” noted the draft. “Sufficient categories are needed to adequately differentiate between different fund types, but the number of categories must also be limited in order to facilitate understanding, acceptance and comparability across funds,” according to the draft. “The solution should be unambiguous and understandable by investors.” Several ways to measure risk or volatility of a mutual fund were considered, including: value at risk, political risk, currency risk and risk/return measures such as Sharpe and Sortino ratios. The risk measurement chosen, however, was standard deviation. “Standard deviation met the subcommittee’s criteria as an unambiguous and relatively well-established and understood measure of risk. Observers continue to argue that upside volatility is important and should be a part of total risk analysis,” according to the draft. “Both upside and downside risk are captured by standard deviation. Standard deviation provides a quantitative framework for assessing fund volatility, however qualitative factors may also need to be considered in order to ensure full disclosure,” according to the draft. “IFIC is not a regulator, which is why these are recommendations,” Mr. Hensel said. “But I believe what we have established is a useful tool for the industry.” More categories Another group developing risk standards for mutual funds, as well as for hedge funds, is the Canadian Investment Funds Standards Committee, a Toronto-based volunteer organization. Its goal is the creation of a single, objective and standardized investment fund classification system for Canada. Toward that end, on April 5, the group released a revised version of its Retail Investment Fund Categories for public review and comment. If acceptance among market participants is broad enough, Canada would become one of the few jurisdictions in the world with such a standard in place, said Chris Adair, chairman of the committee. The CIFSC proposal contains 44 fund categories, mostly based on time-weighted holdings as measured over the most recent three-year period. That is up from the current 38 recognized by CIFSC. Classifying by category Although similar to the IFIC proposal, CIFSC’s classifies funds by category, not by standard deviation. “Everybody should be confident that if a fund belongs to a certain category, it has the risk profile that you expect it to have,” Scott Mackenzie, president and chief executive of Morningstar Canada of Toronto, told the IFIC conference. The committee expects all its members, including Morningstar, to implement the new system with their July month-end data releases. The committee’s approach is similar to the London-based Investment Management Association, which has established fund categories that organize and group funds by their investment objectives and portfolio holdings. Morningstar rejoined the CIFSC on March 6 to become more involved with the risk categorization process after having withdrawn from the committee in February. Other members include the Canadian Life and Health Insurance Association Inc. and Cannex Financial Exchanges Ltd., both of Toronto, and other major data and information providers. “Our mutual goal is to assist Canadian investors in their investment decisions,” Mr. Mackenzie said in a CIFSC press release. “Canadian investors will once again benefit from having a single set of basic categories with which to evaluate mutual funds.” The U.K. categories are not mandatory, but they are designed to help investors identify funds with similar objectives or similar underlying assets.

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