The Canadian Securities Administrators (CSA) are proposing to introduce a mandatory standardized risk classification methodology for mutual funds and ETFs (the Proposed Methodology). Fund managers would be required to use the Proposed Methodology to determine the investment risk level of conventional mutual funds (which must be disclosed in the Fund Facts document) and exchange-traded mutual funds (ETFs) (to be disclosed in the proposed ETF Facts document). Currently, fund managers may determine the risk level of a mutual fund using a methodology of their choosing, though the methodology developed by the Investment Funds Institute of Canada (IFIC Methodology) is widely used by fund managers.
While the Proposed Methodology is consistent with the IFIC Methodology in many respects (including the use of standard deviation (SD) as a risk measure, a five-band risk scale, and the SD ranges for the risk bands), the Proposed Methodology would introduce a number of new requirements and would limit fund managers’ discretion regarding risk determinations. The CSA expects to publish the final Proposed Methodology in the Fall of 2016 and implement it three months later.
Notable features of the Proposed Methodology include the following:
- Applies to both conventional mutual funds and ETFs. While the 2013 Proposal was to apply only to conventional mutual funds, the Proposed Methodology will also apply to ETFs.
- Standard deviation for 10 years. The Proposed Methodology uses SD based on 10 years of a mutual fund’s performance history using net asset value as opposed to market value.
- A series by series risk determination may be required in some cases. The SD calculation under the Proposed Methodology must be made with respect to the series/class of securities of the mutual fund that first became available to the public and the risk level of that series/class will generally be considered the fund’s risk level. The CSA are not requiring that the investment risk level be determined for each series/class of securities of a mutual fund, unless a series/class of securities possesses an attribute that could result in a different investment risk level than that of the mutual fund. In such instances, the investment risk level should be determined for that particular series/class of securities. One example of such an instance provided by the CSA is a currency hedged series/class of securities of a mutual fund which could have materially different performance returns relative to the other series of the mutual fund which may result in a different investment risk level.
- Funds with less than 10 years of history must use a reference index to backfill missing data history. The Proposed Methodology requires mutual funds that do not have 10 years of performance history to use a reference index (or a blend of indices) that reasonably approximates the “return on investment” of the mutual fund to act as a proxy for the missing data. The Proposed Methodology sets out criteria for selecting an appropriate index. If a reference index is used, the mutual fund must describe the index in the fund’s prospectus and monitor the continued appropriateness of the index at least annually. If the reference index is changed, an explanation must be included in the prospectus.
- Exemptive relief from the reference index may be available for fund of funds. For fund of funds, in instances where the underlying fund has a 10 year history and the top fund does not, and the top fund’s stated investment objectives and strategy is to “clone” the underlying fund, CSA staff may grant exemptive relief to use the underlying fund’s volatility of returns for the purposes of determining the top fund’s investment risk level.
- Standard CSA five-category risk scale will be used. In response to comments received, the Proposed Methodology abandons the six-category risk scale presented in the 2013 Proposal, and retains the standard five-category risk scale from Low to High currently in the Fund Facts and in the proposed ETF Facts. The 10-year annualized SD ranges corresponding to each risk band will remain consistent with the IFIC Methodology:
- Low: 0 to less than 6
- Low to medium: 6 to less than 11
- Medium: 11 to less than 16
- Medium to high: 16 to less than 20
- High: 20 or greater.
Significantly, a fund manager may only use their discretion to increase (not to decrease) the investment risk level of a fund calculated in accordance with the Proposed Methodology, if doing so is reasonable in the circumstances.
- Mutual fund “mergers” and changes to fundamental investment objectives. Following a mutual fund “merger”, the SD must be calculated using the monthly “return on investment” of the continuing mutual fund. If the fundamental investment objectives of a mutual fund are changed, the SD must be calculated using the monthly “return on investment” of the mutual fund starting from the date of that change.
- Risk level must be determined at least annually. The investment risk level must be determined for each filing of the Fund Facts or ETF Facts, as applicable, and at least annually. Records must be kept for 7 years documenting how the investment risk level was determined and, if applicable, why it was reasonable to increase it. The CSA comments that the investment risk level may be determined more frequently than annually and that it would generally expect that the investment risk level will be determined again whenever it is no longer reasonable in the circumstances. The CSA would generally consider a change to the mutual fund’s investment risk level disclosed on the most recently filed Fund Facts or ETF Facts, as applicable, to be a material change for continuous disclosure purposes.
Comments on the Proposed Methodology may be submitted until March 9, 2016.
 We refer to conventional mutual funds and ETFs collectively as mutual funds.