Saturday, 2 January 2016

Risk and Complexity of Securities and Funds - a Promising Proposal

How does one know how risky an investment is, whether it's a stock or bond, a mutual fund or an ETF? How complicated and hard is it to understand or predict what the investment's return might depend on? For the retail investor, the basic answer is that you're on your own, having to wade through the security's Prospectus, which for Canadian securities can be found in SEDAR. Trying to compare several alternative possibilities that way is such a nightmarishly time-consuming task that most people likely don't even bother. It's one reason that as my investing years have accumulated, I am more and more oriented to the simplest possible investment structure.

The provincial regulatory authorities under the umbrella of the Canadian Securities Administrators have tried - ineffectually - to help by mandating fund risk rating, the latest revision and supposed improvement exercise of which is currently underway (see Ontario Securities Commission website here). But it relies only on one risk dimension - price volatility - which isn't nearly broad enough to capture real investment risk as I wrote in my last post referring to Howard Marks' fantastic discussion of risk.

Along comes six researchers from Singapore Management University with a promising proposal in A Risk and Complexity Rating Framework for Investment Products, an earlier free version being available here and a $15USD December 2015 version on the CFA website here. Their scheme has been built to work across more or less the whole swath of investing products and asset classes and it looks reasonably workable. In effect, it seems to condense the Prospectus into a rating.

Most important, it seems to capture a much broader characterization of risk and product complexity. Risk, for instance, includes ratings for six items - price volatility, liquidity, credit, duration / cash flow, leverage and diversification. That's a pretty good start, though I would be interested to see them add foreign currency risk and what might be called manager risk, which would assign a higher rating for actively managed funds over index funds, to reflect the fact that most active managers under-perform. As well, some way of including unexpected inflation risk would be very useful, though I cannot think of an easy way to put it in terms of their scheme method.

The rating of complexity is an intriguing proposal and something I like. If a financial product is too complex for me to understand, how can I know how it should fit into my portfolio? It is also likely to disappoint in some way, either by jumping up and biting at the worst possible time, or simply by excessive fee leakage. As the authors point out, "More complex structured products, generally with higher margins ...". Anything more complex than perhaps 3 on their 5 point complexity scale probably should not be available to the average retail investor. It is worth noting the authors' remark that institutional investors, who would likely have the expertise to understand complex products, generally avoid them and stick to basic products. Probably it's because they do understand the products that they avoid them.

The final reality the researchers recognize and try to incorporate is that the behaviour of securities in a crisis such as 2008 can change, notably that correlations of asset types can converge, that liquidity and leverage can have exaggerated effects.

The results of their calibration testing using 100 different funds ended up classifying some of the money market and bond funds with a higher risk rating - at 4 - than a few of the equity funds - at 3 out of 5.  That's an intriguing and useful result, a counter to the too simplistic notion that bonds are "safer" than equities. It sure would be interesting to see our Canadian regulators test the paper's method on Canadian funds and securities. I could foresee a regulatory website where any security's official risk and complexity rating could be found and compared to other user-selected securities.

Thanks to the indefatigible Ken Kivenko, a member of the OSC Investor Advisory Panel, for bringing this fascinating paper to my attention. Go for this one, Ken! According to the paper, no other country has such an investment product rating scheme yet. Maybe Canada could be first in an investor protection move for once?

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