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Risks indicators an education tool

New risk indicators that will be used to describe managed funds' volatility in disclosure documents should help build investor confidence despite their flaws, industry participants say.

Monday, January 18th 2016, 6:00AM 7 Comments

by Susan Edmunds

Under the Financial Markets Conduct Act (FMCA), disclosure statements for products such as managed funds are much more prescriptive.

Managers must include a risk indicator to make it clear to investors how volatile a particular fund is.

The risk indicator runs on a scale of one, indicating very low risk, through to seven.

It is calculated on the basis of the previous five years' returns.

The risk indicator is intended to help investors make decisions by providing them with a way to compare the volatility between various managed investment scheme products.

It is based on annualised standard deviations, calculated using the change in returns from week to week or from month to month over five years.  The more the actual weekly or monthly return differs from the average weekly or monthly return, the higher the standard deviation and the higher the volatility.

But there are concerns that the indicators may be unclear.

Because the system looks back over five years, during periods of significant upheaval, such as the GFC, all funds would look riskier than they really are.

During periods of strong returns, such as experienced over recent years, they may look less risky than they should.

That has prompted calls for another, clearer way to talk to investors about risk, including explaining to investors how a fund would have performed at various points through history.

But Rebecca Thomas, of Mint Asset Management, said the industry had to start somewhere and the risk indicators would be beneficial to investors.

She said while the best measure of performance was the longest history you could get, the five-year system was internationally recognised.

In New Zealand, the introduction of the PIE tax regime in 2007 meant returns before that time were not useful as a comparison anyway, she said.

She said the FMCA regime was meant to be educational and allow investors to compare funds with each other. "It's not saying bonds are better than equities but looking at all the funds and if one is a four and the others are all two, that will give investors an idea of the volatility of the product."

She said the industry had tended to report returns over a very short period and five years was an improvement on that.

Therese Singleton, AMP general manager of investments and insurance, said she was also supportive of the system, although she periods like the recent few years would be challenging to explain with a number.

Singleton said 10 years might be better than five as a basis for the indicator and that was something that could  be put to the regulator for discussion in time.

But she said a five-year period still had merit.

Thomas said there could be problems for investors determining the performance of alternative assets that were not normally included in managed funds.

If managers think the risk indicators will mislead their clients, there are other options they can use if they explain why they are doing so.

Tags: AMP Financial Markets Conduct Act managed funds Mint Asset Management

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Comments from our readers

On 18 January 2016 at 11:04 am Keith Walter said:
Interesting they are still calling them Risk Indicators when they are Volatility Indicators.
Why must we insist on calling them by an emotive term rather than by what they are?
A Risk Indicator would be one which lets a consumer know how likely they are to lose all or a significant amount of their money with no possibility of recovery. That's risk.
Having highly volatile funds isn't a risk unless you can't wait out the low periods.
It's a bit like the term Financial Adviser when what's really meant is Investment Adviser or Life Insurance Adviser....
On 18 January 2016 at 10:46 pm Kimble said:
Oh my goodness, are you telling people that volatile funds aren't risky?

Highly volatile funds remain highly volatile, even over the long term. It's just that the relative level of that volatility isn't as great as the volatility over shorter time periods. (Especially when you look at it in annualised rather than cumulative terms.)

But you have a better statistical measure of "risk" (as you have defined it) that you can present to us? The one that you use perhaps?
On 19 January 2016 at 8:40 am NormanStacey said:
Keith Walker is of course entirely correct. A Finance Company debenture in moratorium has the lowest volatility - but unlikely zero risk.
Investors understand Risk is the possibility of loss of some or all of their capital. It would be a disservice if they were mislead by industry jargon.
On 20 January 2016 at 8:25 am Mr Mojo said:
Errr, Keith, you've nailed that one mate. Jobs at the FMA if you want them.
On 20 January 2016 at 9:48 am Mr UCITS said:
As with any new concept, it is important to understand it's genesis.

The risk indicator was not developed in NZ, in fact it wasn't even adapted for NZ conditions. It was developed in Europe as part of the UCITS IV regulations specifically for UCITS funds. (UCITS funds are a specific category of managed funds which are highly regulated and only permitted to invest in transferable securities - so no physical commodities and no physical property).

MBIE simply changed the name of the indicator and wrote it into NZ regulation. So what that means is we can't change it, like Therese suggests to use a 10 year data sample, because MBIE don't know what that would do to the calculation methodology that they didn't develop. It also means that NZ shouldn't simply apply this risk indicator methodology to just any type of investment or even any type of managed fund. The test has to be that the investment type or fund first fits within the UCITS framework and if it does then it can use the risk indicator. The alternative is for the NZ industry and regulators to develop its own methodology.

If the industry wants a reliable measure of loss then it could always use VaR and present that to customers. The reason that has never been done of course is that VaR is complex and not particularly retail-investor friendly.

The risk indicator methodology took the pan-European regulators and funds industry a numbers of years to develop and its aim was to present a simple graphic to customers (the 1-7 scale) while ensuring that the calculation methodology sitting behind it was robust. It's not perfect and will no doubt be upgraded by the EU regulators in the future, but for now it's probably the best example of a robust and investor friendly risk indicator we have (provided it is applied to the correct investment types as intended by the EU regulators).
On 20 January 2016 at 9:52 am w k said:
@keith: similar to using the term "not achieved" rather than "failed"
@mojo: no chance, fma will NEVER hire someone with practicing experience. the reason is obvious.
On 20 January 2016 at 1:06 pm Kimble said:
The methodology is not so complex that the we couldn't locally fathom how to increase the sample to 10 years. Of course the indicator can be changed. And it should be.

The complaint in the article that pre-2007 returns cant be used is wholly incorrect. Pre-2007 returns are merely adjusted for tax, while post-2007 they're not. That would only have a marginal impact on any volatility statistic.

The problem with using a longer time period, is that the products have to be around for longer before they have enough history for you to reach a comparable conclusion.

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