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Are you feeling lucky punk? Well, are you?

February 21, 2014 by Editor, InvestingForMe

When it comes to choosing investments, I sometimes think investors feel like the punk anxiously staring down the barrel of Dirty Harry’s 44 Magnum. And just like the punk contemplating the odds that Harry’s gun is out of bullets, I think investors anxiously look at a mutual fund contemplating the odds of the fund having another great year. They know the funds’ managers have had a great run for 3 or 4 years, but is that run going to last or are the funds’ managers out of bullets as well and is the fund about to fall?

 

Fortunately, unlike Dirty Harry’s punk, investors have lots of time and the investment industry gives us lots of tools, helping us to make good choices – or do they?

Risk categories: one of my favourite tools when assessing a mutual fund investment – NOT!

In Canada, the regulators dictate that mutual fund companies must examine and make an assessment of each fund’s risk characteristics and then they must assign each fund a risk rating. Each mutual fund’s level of risk is rated on a scale that consists of 5 categories ranging from Low to High.

The regulators also require each mutual fund to publish each risk rating, front and center, on the mutual fund’s Fund Facts sheet. So, as investors we can easily access the fund’s risk rating, and its purpose is to save us the time, effort and education required to make our own assessment of the investment’s risk and whether or not that level of risk is appropriate for our hard earned savings. Sounds good so far, right?

The devil is in the details

Well, here’s where I’m about to disappoint you and maybe raise your level of cynicism when it comes to the investment industry.

The concept of a simplified risk assessment process to help investors to make better investment choices is great, but unfortunately the regulators (in my opinion) have utterly failed in its delivery and execution. Why?

Well, as investment regulators recently explained, the fund managers themselves are in charge of assessing the risks and choosing their own classification category (highlighting is mine):

Currently, the Fund Facts requires the fund manager of a mutual fund to provide a risk rating for the mutual fund based on a risk classification methodology chosen at the fund manager’s discretion. The fund manager must then identify the mutual fund’s risk level on the scale prescribed in the Fund Facts, which is made up of five categories ranging from Low to High. – Canadian Securities Administrators, December 12, 2013

So there you have it in writing. The critical part of the process – the actual assessment of risk and the selection of the mutual fund’s risk rating – has been left up to the mutual fund’s investment managers. Hmmm. That’s right. The very same people that are making the trades, taking the risks, and managing your savings get to rate their own work.

Now, how objective is that? And so how really helpful is that to you and me? Not very! Allowing the mutual fund’s managers to make the risk assessment for their own mutual funds is no different than telling the punk facing Dirty Harry’s gun barrel to close his eyes and plug his ears while Harry reloads his gun. Now, punk open your eyes. Are you feeling lucky? … Ya, kind of like that.

Remember: Because the regulators don’t require these fund managers to clarify which risk classification methodology they have chosen to use, it’s not safe for you to assume that when comparing two mutual funds (each with a Medium risk rating) that you are actually making a true apples-to-apples comparison. The managers just might be using different risk criteria but giving their fund the same Medium risk rating.

Conclusion: don’t get punked when it comes to your investments’ risks

The regulators did their job in drafting a worthy process, creating a very useful tool, but utterly failed when they gave the risk-rating job to mutual fund managers themselves. Unfortunately, this is one of the problems when you have an industry that is self-regulating with no independent body to properly implement proper risk assessments.

It would be so much better if there were an independent rating agency, like the Dominion Bond Rating Service, given the job of assessing investment fund risks. That would make much better sense! After all, they already review and publish risk assessments for bonds, preferred shares and hybrid investments, so why not investment funds?

  

 

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