Fund Facts a good start, but risk rating & suitability get thumbs-down

By Dan Hallett, CFA, CFP on July 13th, 2011

A new regulatory initiative – i.e. Mutual Fund Point of Sale – was launched this year in an attempt to better inform investors about the investment funds in which they invest.  The key feature of this Point of Sale initiative was to provide an investor-friendly 2-4 page document called Fund Facts summarizing each fund’s most important information.  The idea was based on the observation that only a tiny minority of investors ever read a fund’s simplified prospectus (i.e. the document that lays out all of a fund’s details).

There was no shortage of opinions on this Point of Sale initiative – a collaboration of various financial regulators – while it was in the planning stages.  (Including one from yours truly.)  But now the first stream of Fund Facts documents have been rolled out and a central repository has been set up at to house some documents.  (Post Script:  In October, a more comprehensive and user-friendly repository was launched at  Unfortunately, Fund Facts continues to suffer weaknesses in the two most important areas for investors and their financial advisors.

Risk measure

An important Fund Facts feature is a section aimed at summarizing risk.  This is a tall task since risk means different things to different people.  Still, Fund Facts boils risk down to a five-point scale:  Low, Low-to-Medium, Medium, Medium-to-High or High.  This isn’t much different than what was proposed four years ago.  And yet, the scale is meaningless.

For example, most funds investing primarily in larger-company stocks are rated as “medium” risk.  But what does this mean?  It may depend on who you ask but I’m guessing that almost nobody would equate “medium risk” with a 40% to 50% decline in value every 8 to 9 years with a 2 to 4 year recovery time frame.  And yet that’s exactly the kind of downside risk to which such stock funds expose investors.  But that’s not the only problem with this rating system.

While it’s not wide-spread, there are a few instances of sponsors slapping materially different risk ratings on otherwise identical funds.  Consider the BMO Guardian Enterprise – Advisor Class.  BMO rates this small-to-mid cap Canadian stock fund as “Medium-to-High” risk.  Similarly, a virtually-identical version sold under the HSBC banner – HSBC Small Cap Growth – also shows a “Medium-to-High” risk rating.  Both funds are sub-advised by Calgary-based Mawer Investment Management.  But Mawer sells its own version, Mawer New Canada, which the firm rates as “High” risk.

(This discrepancy has existed for some time in the funds’ respective prospectus documents.  This disclosure gap has simply been transferred to the new Fund Facts documents.  Post Script:  The above HSBC fund was previously rated as “High” risk.  But a review of Fund Facts in early 2012 revealed that of the above three small cap funds managed by Mawer, only its own – Mawer New Canada – showed “high” risk.  In other words, the HSBC fund’s risk rating was reduced for reasons that are not clear.)

Why different ratings for virtually identical funds?  It’s a good question to which there is no good answer.  But the explanation lies in the fund companies’ discretion in rating their funds.  The Investment Funds Institute of Canada (IFIC) has published a guidance document in which they recommend a methodology for rating each fund’s risk.  IFIC recommends standard deviation – a statistic measuring how far each fund’s daily, weekly or monthly return deviates from its historical average – as the basis for rating funds.

While many characterize standard deviation as a poor risk measurement, I have a different view.  Those funds that have the most downside risk exposure also tend to have the highest standard deviations.  Also, my thirteen years of quantitative research on investor returns have revealed that investors are more likely to make behavioural mistakes with investments sporting higher levels of standard deviation.  (On this topic see my October 2010 article:  Volatility measures behavioural risk.)

In addition to the above-noted weaknesses of the industry’s risk disclosure, IFIC – in its risk classification document – highlights that their recommendations should not be used by or for advisors, dealer firms or individual investors.  But this is in sharp contrast to the use of Fund Facts, which is replacing the simplified prospectus as the only required point-of-sale disclosure document for investors.

Suitability guidance

Fund Facts contains a section called “Who is this fund for?”.  While some fund companies do a good job of giving suitability guidance, many are a bit mis-guided.  Case in point:  Dynamic Power American Growth.  This high-conviction fund, managed by Noah Blackstein, holds about twenty stocks and features a heavy-trading style that has added lots of value over time – though it’s been a bit of a wild ride.

The Fund Facts for this fund’s A-series units says (and I’m paraphrasing) that it’s suitable for investors who are seeking capital growth over the medium-to-long term.  The Fund Facts for the very same fund’s T-series units includes the same description as above but adds that it’s also suitable for investors “seeking stable monthly distributions”.  These are not two similar funds but rather two series of the same fund – i.e. the identical legal entity.  Accordingly, suitability recommendations should also be identical.  Mandating regular distributions – as is done with T series funds – does not change suitability.

And similar to the risk ratings, identifying time horizons as part of suitability – i.e. medium term, long term, etc. – will again mean different things to different people.  To me, long-term means 7 to 10 years or more.  To many others it means no more than five years.

Fund Facts is a start

I have no shortage of complaints about the new Fund Facts disclosure document.  But I have to give credit where it’s due.  Fund Facts is a step in the right direction and it’s more likely to be read by investors.  But there is a lot of work to do, so I hope that both regulators and the industry will view Fund Facts as a document that should evolve.  In particularly, Fund Facts needs to improve its risk rating and suitability guidance not aimed at fund managers but at better informing its end investors.