Saturday, 14 December 2013

Mutual Fund Risk Classification Methodology - a modest proposal

Regulators are looking for a methodology to stick a label on mutual funds that tells ordinary joe investors how much risk they are taking on if they buy into the fund. The regulators want something that is easy to understand, easy to calculate and implement, stable through time, easy to monitor and uniformly applicable to all types of funds. The proposal is to use monthly volatility over the last ten years, expressed annualized, either of the fund itself if it has enough history, or its benchmark index to make a five level Low to High risk scale.

My modest alternative proposal: take the fund's annual (total) Expense Ratio as follows (maybe adjust the boundary numbers somewhat since this is kinda back of the envelope)
  • Low Risk - under 0.5%
  • Low-Med - 0.5 to 1.0%
  • Med - 1.0 to 1.5%
  • Med-High - 1.5. to 2.0%
  • High Risk - 2.0% & over
Why do I think it's better?
1) It's even simpler and more straightforward to do all the regulators want. There's no fudging about which index to apply to new funds.
2) The general results will in any case be pretty close to the received wisdom about relative risk categories - bond funds have much lower expense ratios than equity funds.
3) It meets a criteria that I found to be curiously missing from the list - the ability of the risk measure to predict the chance and the size of potential loss. Low Expense index funds consistently outperform on average higher cost actively managed funds. The Case for Indexing paper by Vanguard in the USA found "... evidence for the inverse relationship between investment performance and cost across multiple categories of funds, including both indexed and active mandates". Retire Happy blogger Jim Yih compiled some Canadian numbers in Management Expense Ratios Do Matter and found that the longer the investment period, the more strongly low cost funds performed better than higher cost funds. It wasn't a guarantee of outperformance as he points out but we are talking about a risk indicator aren't we? Blogger Michael James on Money did a few calculations on the S&P 500 with various MERs at MER Drag on Returns and found effects that far outweighed Internet Bubble crashes and Credit Crisis tumbles over the long term. Unlike temporary market volatility, MER money is gone, permanently lost to the investor, it's withdrawn every year. 
4) The rating scheme could be extended to ETFs. I have to admit though the scheme is not foolproof. There would need to be a rule that any fund using leverage is automatically in the highest risk category.

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