Rating the risks of investing in ETFs

Oct 7th, 2015
Clients and financial advisors now have the ability to determine the risk of investing in specific exchange-traded funds (ETFs) and to compare them with funds in their peer group, thanks to a uniform risk-rating system created by the Canadian ETF Association (CETFA) in partnership with Toronto-based Fundata Canada Inc. The risk-rating system employs standard deviation - one of the most commonly used measures to gauge the volatility or price risk of an investment - to place ETFs into five risk categories, ranging from low to high. Typically, the higher the standard deviation for a given ETF, the greater is its historical increase or decrease in price - i.e., volatility - over a defined period. The CETFA/Fundata system, however, is not meant to be a permanent fixture. "The CETFA will provide the new risk ratings on all Canadian-listed ETFs as a temporary measure until the Canadian Securities Administrators [CSA] mandates a comprehensive risk-rating methodology for all mutual funds and ETFs," says Pat Dunwoody, executive director of the CETFA. Under the new system, low-risk ETFs must have a standard deviation of less than 6%; low to medium risk, 6% to 11%; medium risk, 11% to 16%; medium to high risk, 16% to 20%; and high risk, greater than 20%. These risk categories are similar to those recommended by the Investment Funds Institute of Canada for rating mutual funds. According to Reid Baker, director of and data at Fundata, a defined set of rules is used to compute the risk ratings of individual ETFs. For example, the starting point is to use the average of the three- and five-year rolling annualized standard deviation of an ETF. If the five-year standard deviation is not available, the three-year annualized standard deviation is used; and if that is not available, the average of the three- and five-year rolling annualized standard deviation of the proxy index is employed. The use of a proxy index must be approved by Fundata. There are additional guidelines to cover situations in which the proxy data is not available and in other special circumstances. For now, the CETFA risk-rating system allows for simple comparisons of ETFs, although Baker says that the CETFA "acknowledges that the rating system is not a comprehensive risk measure and that investors should take the time to investigate the risks of owning any particular ETF and how it compares to its peers." The CSA is working on developing a risk-rating methodology. On June 18, the regulator published for comment its proposals, which will require ETFs to file a summary disclosure document called ETF Facts, which will include risk ratings. Given that comments on the summary disclosure document were to be filed by Sept. 1, the final document is not likely to be ready until some time next year, says Dunwoody. However, the timing depends upon what is in the pipeline at the CSA, she adds. It is also possible that another round of comments will be requested, extending the timeline for implementation. The risk ratings will be published in CETFA's monthly Industry Statistics Report and by Fundata.