Fund Facts - The risk and reward of fluctuation, volatility and standard deviation

 "Democracy is the worst form of government, except for all those other forms that have been tried from time to time." Winston Churchill

I have had some recent discussions with a major Canadian investor advocacy group (FAIR Canada) that had contacted me. Apparently, they saw this humble blog of mine and invited comment on their submissions to the various regulatory authorities.

The group thought that “risk” as pertaining to mutual fund investing is poorly defined. They are appealing to the regulators to augment the information on the new Fund Facts document that must be given to mutual fund investors when they buy a new fund.

I do agree with the investor advocate’s view that the various ways of describing risk are complex and had addressed that very same topic several years ago in my article “Risky Business”.

Not much has changed since I wrote that article but at this moment in time, the security regulators appear to have made a radical U-turn and appear be leaning towards the use of standard deviation as a measure of risk. When I wrote the somewhat contentious (at the time) article in 2009, the regulator would not allow advisers to use risk rulers, standard deviation (or any variant) as a measure of risk. Their view was that the fund company’s prospectus description of risk was to be used.

Unfortunately the industry, advocacy groups, regulators or advisers still cannot all agree on what measure or measures can or should be used to evaluate the riskiness of a mutual fund.

Fund Facts are replacing the prospectus as this important new information document must be given to investors anytime they buy a new mutual fund. This change came into effect June 13, 2014.

The new Fund Facts document contains a graphical risk “ruler” that indicates the volatility of the fund in terms of low risk, low to medium, medium risk, medium to high and high risk. The simple ruler – with a pointer to indicate where you are on the scale, indicates the degree of fluctuation (volatility) of the fund in the past. It does not predict how volatile the fund could be in the future.

        Example (above) of Fund Facts “Risk ruler”. Note pointer indicating “medium” risk.

The advocacy group suggested that more sophisticated measurement tools should be used and additional mathematical concepts or statistical models be employed.

Although I have a background in Mathematics and Economics, I did not agree. The whole point of the Fund Facts document is to simplify. Explanations of skewed binomial distributions and probability theory would hinder, not help in the decision to buy (or not to buy) a particular mutual fund.

Sometimes we can’t see the forest for the trees. Investors need to know one very important thing. Many mutual funds fluctuate a lot in price. Anything that fluctuates in value can potentially make or lose money. The industry including the advocacy groups can’t seem to agree how to tell potential investors that they have a chance of losing money. Bell curves however, aren’t going to do it.

In my initial presentation to a new mutual fund investor contemplating the purchase of a stock-based mutual fund, I always point out that stock markets go up and they go down – sometimes a little - sometimes a lot. How much is a lot? Well during the U.S. Financial Crisis in 2008 and 2009 the benchmark S&P 500 stock market index dropped a staggering 57% (peak to trough). That’s a lot.

The advocacy group described my explanation of risk as “glib”.

[Editor’s note: To be fair to FAIR Canada (pun intended), at least they are reaching out to the adviser community and are asking for comment and discussion. No regulatory authority has ever asked me for input on how to improve our industry and to this adviser - that’s a terrible oversight.]

If I suppose, one’s man’s interpretation of simplifying arcane mathematical concepts is being glib – then I plead guilty to all charges. But I offer no apologies.

In non-jargonized parlance, I’ve described what the buyer of the mutual fund is buying, and what can be expected in the way of fluctuation. In one sentence only. No fancy charts and no crash courses on statistical theory required!

Is the new “risk ruler” effective?

When I showed my 85 year old client the risk ruler of a particular fund, he responded immediately before I had time to discuss what it was or how to use it.

He grasped the concept immediately. Peering intently at the ruler he said to me. “Glenn, the higher the risk of this fund (pointing to the ruler), the higher the chance there is to lose money, right?”

Right!

The Fund Facts document overall will do a very good job of replacing the telephone book sized prospectus and it will be the major talking point of discussion during the point of sale process.

Investing after all, is a process - not a product.

Sure, the Fund Facts document could be improved but it does highlight all of the most important information that an investor should know before buying a mutual fund.

This is a good thing.

ERRATA:  I thought I was contacted by FAIR Canada but was in fact, contacted by SIPA who is a different investor advocacy group. My thanks to SIPA for their clarification. Their web site can be found here: http://www.sipa.ca