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 Unlike temporary market volatility, MER money is gone, permanently lost to the investor, it's withdrawn every year. 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.

Jeremy "Stocks for the Long Run" Siegel says US Stocks Not Over-Priced

Professor and author Siegel lays out a reasonable case in this hour long video lecture that his thesis still holds that stocks provide the best returns in the long run compared to bonds or T-Bills. Apparently the 5th edition of his famous book is to be out soon with updated data contained in the lecture. In the lecture he argues that there is a flaw in the earnings calculation by S&P which biases earnings down and thus inflates the current P/E calculation in Robert Shiller's well-known CAPE (Cyclically Adjusted Price Earnings, which uses an average of earnings for the past ten years instead of only the past year). Siegel says the gigantic writedowns by a handful of financial companies in 2009 following the financial crisis created a huge earnings hole that overwhelmed the continuing profits of most of the S&P 500. The earnings hit overall just wasn't as bad as the S&P calculation portrays. That 2009 hole will persist in the CAPE average for another five years. He says that as a result the oft-cited over-valuation of the S&P 500 based on current CAPE around 25 is wrong and CAPE is actually below the long term average. He blames the messing up of CAPE on 1993 and 2001 FASB accounting rule changes forcing earnings recognition of writedowns (see around minute 43 of the video).

The State of Risk Profiling in Canada - Ouch!

FinaMetrica provides a risk profiling tool to the financial advisory industry worldwide and a version to individual consumers. Here is what they had to say about the state of affairs in Canada in Risk Profiling: Art and Science:

"...

In countries like Canada, the regulator appears to be significantly behind many other countries. The regulatory framework in Canada is complicated with disputes between  the provinces and federal government over jurisdiction and a recent Supreme Court decision recently delayed or derailed attempts at a single regulator. Regulation of mutual funds, stock brokers, banks and insurance firms all fall under different regulatory bodies in Canada further complicating the picture. The investment  regulators in Canada are still substantially focused on product level risk assessments  with little or no framework to look at the client holistically."

Sadly, not very flattering.

Financial Certifications Glossary from IIROC: a Useful Start though More is Needed

The Investment Industry Regulatory Organization of Canada's online glossary of about 40+ financial titles and designations is a good step forward towards lessening the confusion confronting the average person looking for expert advice. The direct weblinks to all the sponsoring / certifying organizations' websites is itself a big timesaver. The listing of education requirements for each designation gives an impression of how substantial and deep the required knowledge base is for each.

My suggestions for additional info for the glossary:
1) Standard of Care provided to Client - does the holder of a designation undertake to provide advice under a fiduciary duty best-interest standard or a suitability standard or something else? This is a hot topic these days as the Ontario Securities Commission considers whether to impose best-interest standards on people who call themselves financial advisors. The glossary indicates whether each designation has an ethics code but it doesn't, and could and should, say what each code promises on this critical point.

2) Subject Matter Expertise - the one thing I as a consumer want to know is "who do I ask about what?" Suppose I want advice on improving tax efficiency of my investments across types of accounts (RRSP, TFSA etc). The designation titles are suggestive but inadequate. Do I look for a CA, a CGA, a CIM, a CFA, a CFP or any of about a dozen or so other possible designations? Is the Distinguished Financial Advisor Tax Services Specialist going to provide me with sound advice? I'd guess not as the impression from the webpage is that they are competent in filling in T1 and T2 tax forms but that's it. A Chartered  Accountant or maybe a Chartered Investment Manager would be a much better bet, despite the absence of the word tax in the title. The head of IIROC says in a Morningstar video interview that they don't want to judge the various designations but surely they can compile and condense into some sort of searchable system what each designation claims to be able to do. Every solid designation should have and should publish its Body of Knowledge such as the CFA does.

Banana Beta: Monkeys Generally Out-Perform the Market

So much for the smug superiority of index investors constantly boasting how active mutual funds fail to beat the market. Yes, that's right, new research is showing that randomly chosen stock portfolios, aka those picked by dart throwing monkeys, would have beaten a market-cap index. Andrew Clare, Nicholas Motson and Stephen Thomas of Cass University tell us so in a two-part study (part 1 and part 2) titled An evaluation of alternative equity indices.

The researchers test a bunch of alternative equity index strategies - equal weighting, diversity weighting, low volatility weighting, equal risk contribution, risk clustering, portfolio minimum variance weighting, maximum diversification weighting, risk efficient weighting in part 1 and fundamental weighting in part 2. For US stocks from 1968 to 2011, the alternative strategies all beat the market-cap index by a substantial amount - 2% per year in several cases - whether risk-adjusted or not. Only in the decade of the 1990s (at the end of which the Internet bubble had not yet burst) did market-cap do best. In the 2000s, market-cap was plain bad while the other index methods did ok.

The simulated army of ten million random-picking monkeys are not to be trifled with, however. As well as knocking the stuffing out of market-cap indexing (I propose we call this "banana beta" to differentiate it from plain ole beta and the new improved smart beta), the monkeys also beat, on average, several of the alternative indices!! Equal weighting barely beats the simians. Equal risk, low volatility, risk efficient and fundamental indexing beat almost all the monkeys convincingly. These, plus maximum diversification, produced risk-adjusted (Sharpe ratio) results much superior to monkeys.

A very interesting other result of the papers is that a very simple momentum following market timing rule would have improved performance tremendously by more or less halving the maximum drawdown of the equity portfolio. Who would have not wanted to avoid the 40% value reduction after the 2008 crisis and only seen a 20% drop? Using this rule, the Market-cap index catches up to the alternative indices. The rule even looks potentially practical for a retail investor, though it would take some conviction to go from 100% in equities to 100% in T-Bills, or vice versa, depending on the signal.

It is isn't possible to invest in ten million monkey portfolios. And judging by their relative performance, I am reassured that low volatility equity ( I own some of BMO's ZLB) and fundamental equity (and some Invesco Powershares PXC) are a reasonable bet. As these researchers also found, I need to remind myself that the alternative indices have not and won't always out-perform every year or over even multi-year periods.

Thanks to Peter Benedek's RetirementAction weekly roundup of news for the link to Larry Swedroe's post on the same study.

Another Way to Invest in ETFs - Buy BlackRock Shares

Believe in ETFs? Want to bet on their continued growth at the expense of mutual funds? Then buy shares in the world's largest provider of ETFs BlackRock (BLK). Today's announcement of a 14% growth in Q3 net income, "... driven mostly by the asset growth of its ETF business..." is rather impressive given the enormous size of the company. Of course, the potential danger is that managers / employees may take most of the ETF-generated profit growth at the expense of shareholders. Or that competition may reduce profitability. But so far that seems not to be the case. BLK's 5-year return is 132% while one of BlackRock's flagship ETFs, the S&P 500's IVV is up 106% and another, the Canadian S&P / TSX 60 XIU is up a mere 51%.

Conference Board Shows Us the Mutual Fund Footprint

The Conference Board of Canada's Making Dollars and Sense of Canada's Mutual Fund Industry tells us that the industry is gigantic. How ironic and perverse. According to the definition of value added on page 2, the more the industry charges over its cost, the more it adds value. Bring on 10% MERs, that would make the industry even more valuable! The more inefficient it is, the better? There is a big missing piece. There needs to be consideration of the cost and value to consumers.This key issue is raised in this quote, "Fund management creates value in the economy through portfolio management activities, distribution channel creates value through the advice a fund dealer provides when selling a mutual fund to an investor". But then the report avoids assessing that critical aspect. Portfolio management that doesn't beat the index - that's value added? Advice from too many fund dealers that consists mainly of selling effort - that's value added?

In the terminology of the report, the industry has a huge economic footprint. Unfortunately the footprint falls heavily on the back of Canadians trying to save for retirement.
(Thanks to Ken Kivenko for the link to the report)