March meltdown reveals fund
risk-rating distortions

April 27, 2020

The sharp market selloff in March affected almost all asset classes. In fact, only two CIFSC categories, Canadian Money Market and U.S. Money Market, posted positive returns. Energy Equity funds saw the biggest decline, falling an average of 32.8%. These funds were affected not only by the COVID-19 outbreak and resulting economic implications but were also the funds most directly impacted by the price war that saw oil prices crater.

Other notable declines include all four Small/Mid Cap categories, which had losses ranging from 16% to 24%, and Preferred Share Fixed Income, which fell almost 20%. Even the supposedly safe fixed-income categories took a hit: Canadian and Global Fixed Income funds dropped by an average of 3.6% and 4.0%.

These types of losses are not out of the ordinary. All you have to do is look back at the drawdowns funds witnessed during the great financial crisis in 2008 or the market crash in 1987. Now, granted, the swift declines and large daily swings we experienced in March were extreme even by historical standards. But bull markets don’t last forever, and investors should expect funds to suffer monthly or yearly losses over the course of a business cycle. However, investors should also be able to expect volatility and losses that are consistent with the stated risk of the investment.

For mutual funds and ETFs, risk ratings are calculated by fund managers using a methodology prescribed by the Canadian Securities Administrators (CSA) that is based on 10-year standard deviation (SD). Over the past few years it has been well documented that market volatility has been on the decline, and as a result, risk ratings have been trending lower. This has led to a mismatch between risk ratings and the true risk of many funds.

Let’s start by looking at the Canadian Equity category. The majority of funds in this category (around 75%) are rated “Medium” risk. In addition, there are two funds rated “Medium to High” risk and 43 funds rated “Low to Medium” risk.

As you can see, the average loss in March for Low to Medium risk was very similar to that of Medium-risk funds. And they actually did worse than the Medium to High-risk funds. The worst Canadian Equity performer in the Low to Medium-risk category lost over 26%!

To be clear, I am not saying that Canadian equity fund investors should never expect losses of this magnitude. They should be aware, based on past market corrections, that these types of drawdowns are a distinct possibility, if not an inevitability. In September and October of 2008, the average Canadian Equity fund lost over 27%. The difference is that back then, Canadian Equity funds, or any equity fund for that matter, were not being advertised as below-average risk investments. Today, around 18% of equity funds have a risk rating of “Low to Medium.” And this includes funds from categories that were normally considered above-average risk, such as Emerging Markets Equity, Canadian Focused Small/Mid Cap Equity, and Real Estate Equity.

Now let’s look at an even more extreme example. Energy Equity funds have historically been considered high risk-investment products. But as you can see below, over half the funds in the category now have risk ratings below High, including three that are rated Medium risk. Ironically, these supposedly Medium-risk funds performed worse in March, on average, than the funds in the higher-risk categories.

One fund in the Medium-risk category managed to lose close to 50%. I think it is safe to say that the typical medium-risk investor would not be expecting to lose half of their investment in a single month. This particular fund does not have a 10-year track record, but at the end February, its eight-year SD was already sitting at 17%. At the end of March, it jumped to north of 24%. This means when the manager renews the fund facts in August, there is a very good chance the risk rating on this fund will change to High, moving up two risk bands. This will do nothing for those medium-risk investors who suffered significant impairments to their portfolios over the past month. And in many cases, advisors will be forced to sell the funds from these accounts, thus locking in the losses, because it will no longer be deemed an appropriate investment based on the client’s risk tolerance.

This is an industry-wide problem, and there are dozens of funds that experienced volatility and losses in March that were entirely inconsistent with their risk ratings. The fact of the matter is that managers were simply applying the methodology prescribed by the regulators. The events of the past few months have highlighted again the issue I have been calling attention to for years – namely that measuring risk based on standard deviation over an arbitrary time period is a recipe for disaster. Recency bias often makes us believe that market crashes are once-in-a-lifetime events, but the truth is they happen quite regularly – not just every 10 years.

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