Introduction
On December 12, 2013, the Canadian Securities Administrators (CSA) published CSA Notice 81-324 Proposed CSA Mutual Fund Risk Classification Methodology for Use in Fund Facts1. The CSA propose to mandate (or adopt as guidance only) that all Canadian mutual funds use standard deviation as the measurement of risk and for risk classification purposes. Once a fund’s standard deviation has been calculated, the fund manager will be required to slot the fund into one of six standardised risk bands proposed by the CSA for the purposes of the simplified prospectus and Fund Facts disclosure. Notably, the CSA have not published proposed rule amendments – the Notice describes the CSA’s proposed methodology, including its proposals for enhanced disclosure, and is designed to elicit feedback on the proposals in advance of rule-making.
The CSA consider a mandatory standardised risk classification methodology to be useful to investors because it would provide a consistent and comparable basis for measuring the risk of different mutual funds. However, the CSA do not explain in detail why the current disclosure practices of the mutual fund industry need improvement. It will be useful to consider exactly how the CSA’s proposals differ from current industry practices – given that most fund managers follow the voluntary guidelines for fund volatility risk classification developed and regularly updated by The Investment Funds Institute of Canada (IFIC).
The CSA assert that standard deviation using the performance data for the past ten years of the mutual fund is the most appropriate measurement, given that it illustrates the volatility of past returns of the fund. A six category risk scale (as opposed to the current five category scale) is proposed for disclosing a mutual fund’s standard deviation and risk classification in the simplified prospectus and Fund Facts documents. No discretion is proposed to be given to a fund manager to deviate from the risk category band that corresponds to its standard deviation calculation. This varies from the current practice where variances are permitted, subject to appropriate disclosure.
The CSA are undoubtedly focusing their efforts on developing clearer, easy to grasp, disclosure of the risks of investing in different mutual funds – but are not losing sight of their aim to ensure that all investment funds provide similar summary disclosure to investors. The CSA indicate that, if adopted for mutual funds, in time, the same proposals may be expanded to other investment funds, including exchange-traded funds and closed-end funds.
Comments are due on the matters outlined in the Notice by March 12, 2014. The ability to formally comment on CSA proposals is an excellent opportunity to help shape future regulation that is in the best interests of investors and is appropriate for the financial services industry in Canada and which does not have significant unintended consequences. The CSA set out 14 specific questions for comment, in addition to asking for feedback on all aspects of their proposals.
Current requirements and practices for risk disclosure
Under National Instrument 81-101 Mutual Fund Prospectus Disclosure, a mutual fund must disclose its risk rating in the simplified prospectus and Fund Facts documents, calculated based on a risk classification methodology chosen by the fund manager, which methodology must be disclosed (and explained) in the simplified prospectus of the mutual fund, and provided to investors upon request. The mutual fund’s risk level is then slotted into a five category risk scale mandated by NI 81-101 for the simplified prospectus and the Fund Facts, which ranges from low to high. Effective January 13, 2014, under the 2013 amendments to NI 81-101 adopted by the CSA, mutual funds must include mandatory introductory disclosure to this risk scale in the Fund Facts documents that is intended to explain to investors that the risk rating is calculated by the fund manager, and also to give investors a better understanding of the concept of volatility.
Fund managers will want to closely examine their current methodology of calculating risk associated with their mutual funds, particularly if they use a methodology that is different from what IFIC recommends. Managers that use the IFIC methodology and guidance as a basis for their risk methodology should also review how the CSA’s proposals differ from the IFIC guidelines and how the proposed methodology might impact their calculations and risk rating assignments. This is important since the CSA ask whether industry participants consider a different methodology than what they propose to mandate, to be more appropriate – and if so, why.
Features of the proposed methodology
The primary features of the proposed CSA methodology are as follows:
Risk Indicator: The CSA propose that all mutual funds calculate risk using standard deviation. Standard deviation is considered to measure how returns vary over time (or deviate) from the average return and hence, measures the volatility of investment returns.
Calculation of Standard Deviation: Annualised standard deviation must be calculated for a mutual fund (the CSA provide a proposed formula) using the monthly total returns (i.e. reinvesting all income and capital gains distributions) of the fund over the past 10 years
We query whether a ten year performance history is the appropriate time period and whether any additional disclosure around returns might also be beneficial. The CSA’s proposed methodology excludes the use of qualitative factors or fund manager discretion to override the quantitative calculation for risk classification purposes. This constitutes a significant difference compared to the current IFIC guidelines, which provides that a fund manager’s discretion is valuable and should be used, and, qualitative factors should be applied, where appropriate, in the interest of ensuring full, true and plain disclosure.
For new mutual funds or mutual funds with less than 10 years of performance history, the fund manager will be required to use the monthly returns of a reference index to fill out the return history. We note that this means that the risk classification of a new or newly created mutual fund would be based entirely, or mostly, on the reference index, although we foresee significant practical difficulties in determining which reference index to use for such mutual funds, given the CSA’s proposed guidelines for selecting a reference index:
- It must have wide recognition, no affiliation with the fund manager and be publicly available
- Its returns must be highly correlated to the returns of the mutual fund (anticipated returns for a new fund?)
- It must have a high proportion of the securities represented in the mutual fund portfolio, with similar allocations (anticipated portfolio for a new fund?)
- It must have a similar historical systemic risk profile (anticipated profile for a new fund?).
For multi-asset class portfolios, the CSA acknowledge that it may be appropriate for a fund manager to build its own blended index from a weighted combination of acceptable reference indices to impute missing data. The reference index would need to be monitored at least on an annual basis for appropriateness and disclosed in the mutual fund’s simplified prospectus.
Standard deviation would be shown for the fund as a whole: The CSA propose that a mutual fund would calculate standard deviation based on the total returns of its oldest series. Fund managers will not need to calculate standard deviation for each series of a fund, unless an attribute of a particular series (for example, one that carries on currency hedging) would result in a materially different level of volatility risk for that series, in which case, the fund manager would use the total returns of that particular series to calculate the series standard deviation.
Disclosure of risk in fund facts: The CSA propose to mandate that a mutual fund’s standard deviation be disclosed by identifying where the fund fits on a six category volatility risk scale. This scale and these categories differ from the current scale recommended in the IFIC guidelines and mandated by the Fund Facts form requirement:
- Low – standard deviation of 0-2%
- Low to Medium – standard deviation of 2-6%
- Medium – standard deviation of 6-12%
- Medium to High – standard deviation of 12-18%
- High – standard deviation of 18-28%
- Very High – standard deviation of more than 28%
It is not clear whether the CSA will require disclosure of the specific standard deviation in addition to simply showing the scale and where the fund fits on that scale. We also query whether the additional category of ‘Very High’ is necessary and whether the numerical scales (0- 28% and beyond) and ranges are appropriate or, if these should be adjusted in any way.
The CSA acknowledge that the new risk scale will potentially affect mutual funds – and distributors of those mutual funds – where the mutual fund will have to disclose a different risk band from what it currently discloses, but point out that this shouldn’t be taken to mean that the fund’s risk has changed – simply that the required disclosure has changed. These changes can be expected to impact suitability assessments by dealers and advisors and, presumably, will require changes to dealers’ processes to evaluate and monitor the risk of their clients’ investment portfolios. This could have a significant impact on these operations and therefore, any implementation of the CSA’s proposals should provide for sufficient transition periods to allow registrants and self-regulatory organizations to address these issues and minimise the impact for their clients. One could question whether the benefits to the investors of changing the standard deviation bands are worth the confusion that such change may cause in the market and the costs that the industry will need to bear to adapt its systems and processes accordingly.
Required monthly monitoring of standard deviation: The CSA propose that fund managers monitor standard deviation of their funds on a monthly basis. Where a new monthly calculation shows a different standard deviation, which causes the fund to fall within a different risk band (either higher or lower), the CSA indicate that they would consider this to be a material change for the fund. This event will necessitate a press release and an amendment to the various disclosure documents, as well as a material change report, to be filed within ten days of the monthly calculation of the fund’s standard deviation. The CSA suggest that this kind of dramatic change should occur only rarely. This expectation should be considered carefully by industry participants, given the obvious disruption and regulatory burden, if standard deviation will regularly change over time under the CSA’s proposed methodology. We also question whether a monthly calculation is necessary, if as the CSA believe, standard deviation for a mutual fund should not change much from month to month. It may be more appropriate to maintain the same annual review as is recommended in the IFIC guidelines.
Reminders
All mutual funds must file revised Fund Facts documents in the new format (required as of January 13, 2014) on or before May 13, 2014. The time that must be devoted to this exercise should not be underestimated and we recommend that fund managers start the process to develop the revised Fund Facts as soon as possible. We are working with many fund managers to help them to meet this deadline and would be pleased to answer questions or assist you in any way you may require. Dealers will be required to provide the Fund Facts documents (in the new form) to investors in lieu of the simplified prospectus of the funds for trades made on and after June 13, 2014.
Rebecca Cowdery is a partner in the Toronto office of Borden Ladner Gervais LLP. Rebecca practises corporate, commercial and securities law, focusing on the investment management industry. Rebecca has over 25 years of experience in working with the investment management industry as a lawyer and a regulator (OSC). Among other things, Rebecca works with fund managers to establish new products and to manage funds in compliance with applicable regulation, including fund governance. She participates in many industry committees and is well versed in the regulation of funds, their managers and their distributors. Rebecca is a frequent speaker and writer about topics in the investment management industry and also leads BLG’s lean project management program – BLG Adroit.
Eric Lapierre is a counsel in the Montréal office of Borden Ladner Gervais LLP. He practices securities law and insurance law. His areas of practice include the management of investments and, more particularly, investment funds. Eric is a seasoned speaker on matters relating to investment funds. He has been a member of various national and international committees on investment funds, investment management and systemic risks. Before joining BLG, Mr. Lapierre was Chef du Service des fonds d'investissement at the Autorité des marchés financiers, and the general manager and legal counsel for one of Canada's most important investment funds corporate groups. Francesca Smirnakis is an associate in the Toronto office of Borden Ladner Gervais LLP. She practises corporate, commercial and securities law, focusing on the investment management industry.
Francesca advises Canadian investment fund managers, dealers and investment advisers on legal issues relating to the establishment and administration of investment funds. She also advises international investment fund managers and advisers on offering and advising investment funds in Canada. She has been involved creating many investment products including mutual funds, exchange-traded funds, hedge funds, closed-end funds and pooled funds. Francesca also has experience in merger and acquisition transactions in the investment industry.
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