At the root of all positive change is inconvenience. Teaching your child to tie his shoes is inconvenient; continuing to buy ones with Velcro fasteners is convenient. Working out at the end of a long day is inconvenient; flopping down on the sofa and telling yourself you'll start tomorrow is convenient. Breaking free from something familiar is inherently inconvenient; staying with the familiar is much easier.
So it is, apparently, in developing a standard for disclosing the risk of mutual funds. In proposing risk classifications based on standard deviation, the Canadian Securities Administrators (CSA) has opted for convenience rather than for positive change.
The CSA, representing securities regulators across the country, wants to improve on the current risk-classification regime, which allows fund managers to choose their own methods of measuring risk. This is a worthwhile objective. But is standard deviation -- a statistical measure of the dispersion of returns -- good enough to do the job?
The CSA thinks so, according to its notice and request for comment released in December. The regulators contend that standard deviation has a well understood and established calculation methodology, that it provides a consistent risk evaluation for a broad range of investment funds, and that it is already widely used in the industry.
The CSA essentially concludes that standard deviation is the most convenient measure. It's not the best measure, but it's deemed good enough. Choosing another, potentially better measure, would have been inconvenient.
There are two significant problems with the CSA's proposal. First, standard deviation does not reflect investors' perception of investment risk. Second, the regulators run the risk of implying that risk can be distilled into a single number.
For most investors, sophisticated or not, risk is the potential for losing money. If they invest $10,000, for instance, they want to know what the risk is of losing $5,000 of it. Standard deviation measures the spread of returns around a mean value. Therefore, any value above the mean (positive returns) carries exactly the same weight as a value below the mean (downside risk). As a result, standard deviation punishes positive performance.
This is not investment risk as most investors perceive it. It does not seem logical that many investors would see upside deviation as an important "risk" factor to consider. On the contrary, earning positive returns is the whole point of being an investor.
For most investors, risk is perceived as both the likelihood and magnitude of potential losses: What's the likelihood I could lose the money that I invested? How much of my investment could I lose?
What the regulators should do is propose the best risk measure that measures the potential to lose money.
Conditional value at risk (CVaR) is a better measure than standard deviation because it better reflects the potential for an investor to lose money. Instead of measuring how returns are dispersed around the mean, CVaR focuses entirely on possible losses -- both the potential magnitude and likelihood. Since CVaR provides a summary of how severe losses can be, it is a much more useful and meaningful risk measure than the ubiquitous standard deviation.
CVaR is enjoying a widespread and growing popularity in the institutional investment world and will undoubtedly become more popular in the retail investment space. Canada's securities regulators now have an opportunity to embrace a better, if imperfect, measure for investment risk.
The other significant shortcoming of the CSA's proposal is that in proposing a standard risk indicator, it can imply that risk can be summed up in one simple data point. Investment risk is multi-faceted; trying to distill it into a single number implies that it is the only measure of risk that needs consideration. On the contrary, there are numerous risk factors to consider. Among them are systematic factors such as equity risk and interest-rate risk, as well as security-specific factors.
At Morningstar, our March submission to the CSA reflects our corporate view that single risk measures are risky and that there are better ways to measure the risk of losing money than standard deviation.
We believe that CVaR is a far better way of measuring the risk for investors of losing money than standard deviation -- but we welcome the debate. Good enough is never good enough when better is staring you right in the face.
