Complex Funds Need Better Risk Disclosure

Risk matters as much as return in any mutual fund investment, but assessing the risk of a specific mutual fund can be a challenge. Even though mutual funds have become increasingly complex, their risk disclosure was designed for a simpler era, when funds used only traditional investment strategies.

Funds continue to inform investors about risks primarily by using words. In the prospectus sent to fund buyers, funds describe the types of investments they may own, along with discussions of the factors that may affect the value of those investments.

Verbal risk disclosure worked well when funds held publicly traded stocks and investment-grade bonds. The risks of the underlying assets – which were well understood and easily compared – equated to the risk of the fund.

However, as funds began to venture into non-traditional securities and investment techniques, this qualitative approach to describing risk created as much confusion as clarification. Funds added a paragraph of disclosure for every new asset type or strategy that they thought they might want to use.

Pulling a comprehensive view of a fund’s risk from this voluminous disclosure is no easy task. Is a blue-chip stock fund that uses short sales and derivatives extensively riskier than a high-yield bond fund that engages in the occasional credit default swap? Or is it vice versa?

To help investors better evaluate overall risk, regulators require that funds highlight the most relevant risk factors. These key risks are at the core of the summary fund descriptions sent to potential buyers (called the summary prospectus in the U.S. and the key investor information document or Kiid in Europe.)

And since regulators recognize that a picture is worth a thousand words, these summary documents must include a bar graph showing how a fund’s past performance has varied from year to year. These charts do make it easy to evaluate volatility, but only if the fund has been around long enough to experience a full market cycle using the same investment approach.

To make comparisons easier, European regulators also require that funds provide a synthetic risk and reward indicator, ranking funds on a single scale from one (least risky) to seven (most risky). While useful in concept, the SRRI may not be providing much insight to investors, since funds investing in similar assets generally all fall within the same one or two SRRI categories. In addition, the SRRI is calculated from past returns, giving it the same limitations as the performance bar chart.

What fund investors need are standardized risk measures that are objective, quantifiable and forward-looking. Here are two such measures that regulators might consider.

Leverage limit: Leverage is directly correlated with risk. It is also a tool that more and more funds are using, most often through derivative securities.

Funds might be required to publish a limit on leverage, so that investors can understand how much market exposure they will have relative to their investment. This limit might range from one times assets – for a traditional fund – to three times for an aggressive fund using derivatives extensively.

The published leverage limit would help ensure that investors find the fund that is right for them. For example, a retirement plan sponsor may limit fund choices to those with lower leverage limits, while an aggressive investor may seek out funds with higher limits.

Non-traditional investments: Funds have long moved beyond blue-chips stocks and bonds and now offer investors access to a wide range of asset classes. Investments in derivatives, commodities or real estate are readily available to fund investors these days.

While these alternative asset classes provide investors with increased diversification, they are subject to special risks. They may be more difficult to price – and more likely to experience wide swings in valuation during market turmoil. Derivatives and other structured securities are subject to counterparty risk, meaning that their value depends on the solvency of the financial institution guaranteeing payment.

To give investors a sense of their exposure to these risks, as with the leverage limit, funds might be required to disclose their maximum percentage in alternative assets that are less liquid or hard to value. This disclosure would only be needed if the name of the fund did not indicate that it focuses on alternative investments.

But to ensure that product innovation is consistent with investor protection, the fund industry needs better disclosures. Greater use of standardized, quantitative risk measures would help investors choose among new types of funds.