Developing a risk rating methodology

The European Commission wishes to enhance the UCITS Directive and sought advice from the Committee for European Securities Regulators (CESR). To this end CESR published three consultation papers concerning the proposed Key Information Document (KID) for UCITS funds.

As part of these consultations CESR asked for views on the relative benefits of using a standardised synthetic risk indicator, which provides investors with a pictorial representation of where the risk of an individual fund sits on a scale, rather than a narrative approach to risk disclosure. CESR has now issued its advice to the European Commission. This paper aims to inform the ongoing debate, by assessing how to calculate a standardised risk disclosure metric. This is extremely important, because without a standardised approach to calculation it would be misleading for investors to standardise the pictorial representation of risk. In these papers CESR outlined its proposals for improving the key documentation that investors are provided with when they buy an investment fund, and for standardising the way in which this information is presented within the KID.

This report therefore provides analysis and views on whether it is possible and/or desirable to use a single measure of risk to categorise a wide range of investment funds, from traditional long only funds to more complex structured products. In effect it provides views and analysis about the appropriate empirical engine that should be used to drive an EU-wide risk rating process. The work has three main, related objectives:

• the proposed methodology should be able to produce a rating that would be both reliable and easily understood by non-financial experts;
• it should be simple to calculate and to replicate (to avoid inconsistencies between providers); and
• it should have the potential to be applied to a wide range of investment funds and products.

In order to assess reliability, the paper examines how successful different risk metrics are at producing consistent risk rankings over time. This is important, because if rankings applied to individual funds shift frequently and by large amounts, this is likely to confuse investors and undermine the value of the risk indicator as a decision tool. While it is difficult to forecast the level of risk from one period to another, the main empirical findings in this report show that it is possible to forecast the relative risk rankings of broad asset classes from one period to the next using relatively simple and largely volatility based risk measures. Of the range of risk metrics investigated in this report, standard deviation provides the most reliable forecast of future risk rankings. It was also found that in general, the longer the period used to calculate the risk measure the more reliable the subsequent results. This report also argues that an asset class based risk rating process that makes use of standard deviation as the underlying risk metric, could also be extended to incorporate multi-asset class funds, absolute return funds and possibly to structured products of the capital guarantee kind too. Finally, the report argues that fund-specific details relating to each fund’s appropriate investment horizon, tax implications, guarantees and to fund manager-specific risk are best dealt with in the disclosure document, and by financial intermediaries.

Overall this report provides the guidelines necessary for standardising the measurement of risk so that it can be applied to a wide range of investment funds in a way that will allow investors to make meaningful comparisons between one fund and another.