Canadian securities regulators may be putting investors at risk. They implemented a new mandatory risk weighting system in September 2017 based on 10-year Standard Deviation. Every Canadian mutual fund and exchange-traded fund (ETF) must now include a risk rating based on the following:
Before implementing this policy, the Ontario Securities Commission (OSC) asked for submissions from the industry. These can be viewed here.
Over 50 submissions were received (mine included) and out of those, three warned about the deficiency that Standard Deviation does not differentiate between upside and downside volatility.
Scott C. Mackenzie of Morningstar made a particularly succinct comment:
“A conservative investor’s portfolio that is missing a key sector or asset class, essential for prudent diversification (and risk reduction), may demand the inclusion of a small amount of a concentrated sector mutual fund or ETF. A single measure risk score for such a vehicle may be higher than recommended for the investor and they are consequently dissuaded from incorporating it. The irony and potential downside is that the risk of the conservative portfolio may actually be higher than it otherwise would be had the investor included the diversifying the investment.” “Diversification as a risk-reduction activity is a sensible approach, practiced by many, and supported by decades of investment research.”
There are two major flaws with the methodology:
This policy will not protect investors from experiencing losses, but may prevent investors from structuring portfolios for reduced volatility, optimal performance and effective diversification. The resulting reduction in investment demand in sector funds will result in a negative impact for many Canadian public companies.
The overall weakness of this approach is best exemplified by the fact that Bernie Madoff’s fund had the lowest Standard Deviation in the industry for over 30 years – yet investors lost most of their money.
David Ranson of H.C. Wainwright & Co. published a report entitled “Why Standard Deviation Won’t Serve to Classify the Risk of a Portfolio.” This report details why Standard Deviation is a poor and overly simplistic approach to measuring the risk of a portfolio.
“The riskiness of an investment product cannot be represented by the Standard Deviation (volatility) of its historical returns, or by any other single statistic.” “On a real risk scale, cash could be assessed as risky and gold as safe.”
As an example of how flawed this policy is, Morningstar Canada lists 9,412* equity classes of mutual funds. Of these, 1,932* have 10-year performance histories. The best-performing fund is the TD Science and Technology Fund, which achieved an 18.00% 10-year annualized return net of MER. A $10,000 investment in 2007 would now be worth $66,554*.
On the other side of the performance scale is the Brompton Resource Fund. It ranks as 1,932* (last) in performance and has experienced a -21.8% annual decline over the same 10-year period. A $10,000 investment ten years ago would now be worth only $643*.
