What is a risk rating and how does it apply to your investments?
By ATB Investment Management Inc. 23 March 2021 4 min read
In the grocery store breakfast isles, you may see sugary cereal branded as being “high in calcium” or a “good source of protein”. Most consumers know that sugary cereal is often highly delicious rather than being highly nutritious.
For some people, just having the label of being “high in calcium” is the deciding factor in terms of whether or not they buy the cereal. But, for others, they know that cereal is only one component of their overall diet and this label of “high in calcium” is only one factor they should be considering when choosing the foods they buy.
We can think of investment fund risk ratings the same way. While a risk rating of low or medium risk might sound nice, a deeper dive is required before making an investment decision. Let’s walk through some of the basic features of risk ratings and how they can impact decision-making.
What is a risk rating?
Every investment carries a certain amount of risk. The way investment risks are perceived is unique to each investor and their circumstances. To guide the process of determining a standardized and measurable level of risk, the Canadian Securities Administrators (CSA)—the umbrella regulatory organization for Canadian securities commissions—prescribes a method to calculate and classify risk for investment funds.
As an investment fund manager, ATB Investment Management Inc. (ATBIM), follows the CSA’s methodology and assigns a level of risk to each fund on an annual basis. This assigned level of risk, the risk rating, is measured by calculating the standard deviation (a measure of variation or dispersion of a dataset relative to its average) of monthly returns over a 10-year period. If a fund does not have a 10-year history, an appropriate benchmark’s returns are used to fill the full length of the period. The calculations for an all-equity portfolio with a 3 year time period, would combine the three year history from the fund itself and seven years from an all-equity fund being used as a benchmark. The calculated values of standard deviations are assigned a rating on a five-category scale from “Low” to “High” based on prescribed standard deviation bands.
What changed for 2021?
As we all experienced, 2020 was a volatile year for the stock market. The dispersion of returns was quite significant with many broad market indices seeing sharp declines of over 20% towards the beginning of the year, only to finish the year on a positive note.
This volatility contributed to a higher standard deviation for many investment funds, meaning their level of variation increased with the high and low swings in 2020. This impacted the rolling 10-year calculation and shifted the risk rating for two ATB Funds. The risk rating, as defined by the CSA, has changed from “Low” to “Low to Medium” for the CompassTM Balanced Portfolio and from “Low to Medium” to “Medium” for the ATBIS Canadian Equity Pool.
How does ATBIM view the risk ratings?
The risk ratings for the Compass Portfolios and ATBIS pools are largely set to comply with regulatory requirements. As previously mentioned, the risk rating methodology focuses on the rolling 10-year standard deviation. This looks at risk from a relatively narrow lens. When our portfolio management team thinks about risk, they take a more holistic approach and consider future risks, not just the past risk that is reflected in the 10 year standard deviation.
As an example, an all-equity portfolio might experience a risk rating downgrade from “high” to “medium” year-over-year as a volatile year falls off the 10-year rolling average calculation. From a regulatory perspective, the risk rating has dropped, but from a portfolio construction perspective, there have been no changes and the all-equity portfolio should not be viewed as less risky.
If we look at the rating change for our ATBIS Canadian Equity pool, there were no changes in portfolio structure to introduce additional risk, despite the change in risk rating that it experienced this year. This risk rating change is due to the fact that last year was a volatile year and it is now included in the rolling average for the standard deviation calculation.
We can bring in our cereal example here again. Just because a cereal is labelled as “high in calcium”, doesn’t mean it’s not also high in other ingredients that are bad for our overall health. It’s about looking at the full picture. Our portfolio management team would look at risk in terms of overall asset allocation (split between bond and fixed income), geographic diversification, manager diversification along with various other aspects of a portfolio combined with the current and projected state of our economy. This allows them to think of risk outside of a single metric.
How should a client view the risk ratings?
Broad labels such as the risk ratings, should not be viewed at face value. Each investor has a different tolerance for risk. Some investors are more conservative than others when making their investment decisions. It is important that investors take into account their comfort with risk as well as the amount of risk suitable for their financial circumstances and goals. The risks associated with investing in a mutual fund include the risks associated with the securities in which the mutual fund invests.
When investors make investment decisions, we recommend that they consider the different types of investments made by a fund, its relative return over time, and its volatility. Risk ratings - which are solely focused on volatility - should be a factor in the decision-making process but they shouldn’t be the only item reviewed.
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