Why fund investors should be wary of EU risk ratings
By: Tim Bennett
31.05.2018
The EU’s “one-size-fits-all” approach to regulation could lead fund investors astray. Tim Bennett explains why.

Why fund investors should be wary of EU risk ratings

As part of its regulatory overhaul, MiFiD II, the EU requires funds to issue a Key Information Document (KID) that should contain most of the information that investors need to make an informed decision. However, not everyone is convinced;
So what are the critics unhappy with and how does it affect fund investors?

What is a KID?

As Kay notes, the concept of having a KID for funds marketed at retail investors in particular is sound enough. It makes sense to have key information gathered in one, relatively short document so that investors can understand what they are buying and make comparisons with other similar products.
However, Kay and others are less convinced by the risk rating system that is a key part of the KID and something that investors are likely to rely on when weighing up a fund. Again, in principle a simple risk rating from 1 – low risk, to 7 – high risk should work. However, critics point to at least three problems that render the KID and its risk rating system, much less useful than they may seem.

Use of past data

What the KID tries to do is to estimate what you might get back under different scenarios labelled with language that is intended to be user friendly, such as “unfavourable”, or “favourable”. The main issue here is twofold. First off, this terminology is undoubtedly simple, perhaps even borderline “idiot-proof”, but the terminology is not explained. What the word “favourable” means to one investor may be very different to another. The next problem is that the extrapolated annual return needed to offer a projection of possible performance is drawn from the previous five years’ data. As such it is based on a period that saw unprecedented liquidity boosts from central banks. The obvious question is just how representative are these projections likely to be as a result?

Assumptions about risk

The next problem is the KID uses a volatility-based formula (“VEV”) as the basis for its risk ratings. Whilst this has been devised by a panel of “experts” it makes some pretty conventional assumptions about risk and, Kay argues, will tend to push investors towards low volatility, high liquidity funds. This may not seem like a problem until you consider that it leaves little room to exploit opportunities that arise when institutions herd into precisely these kinds of funds and push their prices up as a result. It also ignores the fact that risk is investor-based and should take account of their objectives over the long-term. Instead, the KID focuses on what they might lose over the short-term.

Single product focus

The final criticism, which can be levelled more widely than just the KID, is that the EU has a single product-focus which is reflected here but also in other parts of the regulations. Whilst this may make sense for a continental investor being sold a single fund “off the shelf” by a bank, it ignores the fact that many UK retail investors run diversified portfolios that may include several funds. It is how the fund contributes to the overall risk/return profile of that portfolio that matters, not how the fund is viewed in isolation. Critics argue that the KID rather overlooks this point in an attempt to make “one size fit all”.

Conclusion

The KID makes Kay nervous. In summary;
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