One of the things that we take pride in here at National Capital is our constant drive to research everything and anything that has to do with KiwiSaver in order to give our clients a full picture of their investment position.
This particular piece takes a look at the risk indicator you would have noticed attached to any fund description in the Product Disclosure Statements distributed by the KiwiSaver Scheme providers. First and foremost we take an in-depth look at the purpose of this number and how it is calculated. We take a look at the rules around these calculations and most importantly we assess whether this particular number truly offers a real advantage to the investor and other concerned stakeholders or not.
The Financial Markets Authorities of New Zealand has adopted a set of rules that dictate that all the KiwiSaver Scheme providers must include a risk indicator in their fund descriptions. The fund or scheme must have a calculated risk value indicating the level of volatility that it contains.
The aim of this risk analysis system is to allow investors to make informed decisions when picking funds to invest in. Furthermore, it is designed by adopting the same principles and processes advocated by the Committee European Securities Regulators (CESR) with the aim of calculating a “synthetic risk and reward indicator” for key disclosure documents. It was developed in order to try and make the risk assessment process simpler. Furthermore, it is also designed to be
The FMA guidance, which is based on the SRRI (Synthetic Risk and Reward Indicator) used on KIDs (Key Investor Information Disclosure - the European equivalent of a Product Disclosure Statement) and formulated by the CESR (Committee of European Securities Regulators)
They have tried to make this guide as thorough as possible. The Committee of European Securities Regulators (CESR), the original developers of this guidance, have stated that they have consulted with many field specialists and regulation authorities. The end result of these consultations is the System of Risk and Reward Indicator (SRRI) as we will come to know it. It is designed to be a compromise between the different parties so that this system can give investors a meaningful demonstration of the level of risk associated with a particular fund or other.
The Financial Markets Authorities (FMA) deem this guidance as necessary because it doesn’t just dictate what must be done. It also shows fund managers and supervisors how they must formulate their Product Disclosure Statements and the expectations the FMA has when said managers or supervisors:
The Committee of European Securities Regulators (CESR) decided that the risk indicator must be based on the volatility of the fund. The volatility itself must be calculated using the past weekly returns of a fund and if the weekly returns are not available, monthly returns may be used. These returns must be calculated using a timeline of 5 years of historical data and any dividend payouts or other relevant earnings must also be taken into account.
The FMA has also based their framework on the above way of calculating risk. It has also added that if it is not possible to use a 5 year period of historical returns for reasons such as the fund is not old enough to have been through a five year period, the provider must use a mixture of available figures and relevant examples in the industry or market index returns. The relevant examples must be widely used and/or recognised and the manager of the fund must have no relation to the scheme at hand.
It is up to the fund manager(s) to assess whether the methodology used gives an accurate indication of the risk associated with the scheme. If not, it is their duty to use one of the other methods proposed by the CESR provided to best indicate the risk.
If there is no methodology presented by the FMA use an external methodology that properly displays the amount of risk associated with the fund. If there are any doubts about the correctness of the methodology, contact the FMA before using it to discuss and present the method.
Once the standard deviation for a fund is calculated, the FMA expects one to use the table of numbers they have available that describe the different degrees of a fund’s volatility risk. They have 7 different categories and a fund manager must choose the one best describing their fund. One can also use words to describe the risk but this is not a requirement. If one does choose to use words, the words used in the categories provided by the FMA must be used.
The categories are 1-7 with 1 being the lowest risk - lowest returns and 7 being the highest risk - highest returns mark.
While we all appreciate the work that both the FMA and the CESR have put into this system and making it easily understandable by several stakeholders there are a couple of things that need to be pointed out.
The reliance on past volatility could be a downside because it only shows past performance - no prediction of the future. Using the risk indicator alone is not enough. It gives you some indication of the risk associated with the fund but not a full picture as the aforementioned authorities might have hoped and designed the system for.
It is describing volatility - not risk, and that is the downside of the so called ‘risk indicator’ of the FMA. To properly assess the risk you need to dig in much deeper and look at the assets, what the diversification of these funds is. We also need to go back to the definition of risk - the chance of losing your money. By assessing risk for what it is - the potential chance of losing your money - it opens up a new avenue of what this risk indicator could be.
Furthermore, there is the potential for confusion - several funds with different asset allocations falling within the same category of risk measurements. This means that these funds technically have the same level of risk associated with them when in fact, the asset allocation could indicate otherwise.
If past performance is no indication of future performance, then why is the FMA promoting the use of past risk as an indication of future risk. Especially using such a short time frame as is 5 years when in reality if it wants to use this method it should use a much longer time horizon allowing for accountability of different economic conditions and many more market cycles.
The FMA warns managers that they must be careful not to be misleading when naming these funds as names must not be misleading in regards to risk category and volatility, and also the types of securities these funds contain. However, they do not give any indication of what the names may or may not be misleading and add that they cannot give a definitive list of names and circumstances that may be misleading. Nor do they give a list of other methodologies that can be used in case the one presented by the FMA does not apply. They do however instruct that methodologies proposed by the CESR may be used if the one they proposed is not the right one for all cases.
In order for fund managers and providers to research and do a deep dive of what fund names and methodologies may or may not be used they must use time and resources. The FMA states that it is the obligation of the provider to assess what methodology is appropriate for the particular fund they manage.
This time and resources must come from somewhere. This poses the question, “Who pays for this?” Is it the fund managers and providers out of the fees they are already charging the investors for managing these funds or will they need to increase their fees in order to compensate for the new time and effort potentially required to find the appropriate methodologies and terms necessary to satisfy the FMA. In addition, should, for whatever reason, the FMA not be satisfied with the initial methodology and names used by the fund managers, they can request a reassessment and a new case presented. This also requires more time, effort and resources. So, reader, you see where I’m going with this.
While it is useful to have a framework that can give all parties involved and particularly investors an indication of the risk associated with the funds they plan on investing in, the currently proposed system leaves a few major points up for discussion.
In order to determine the risk in a KiwiSaver fund it is recommended that you look at more than just past returns and volatility of a fund. You need to be seeing the bigger picture and have a holistic view of the fund, the fund managers and the provider as a whole. Even National Capital before it engages in assessing a provider and giving their clients a KiwiSaver scheme comparison it looks beyond past returns. Here at National Capital we look at the asset allocation, who the people are managing your money and most importantly what are the investment policies and processes that these fund managers are basing their investment decisions on. We are digging in deeper into documents like their SIPO (Statement of Investment Policies and Objectives) and overall doing a whole lot of research in the background to ensure that we can confidently recommend a fund to a client that suits the level of volatility they are comfortable with while simultaneously ushering them to achieve the best possible outcome in their retirement or first home deposit goals.
So, as you can see, a lot more goes into determining how risky a fund may be and having a financial advisor on your side is highly recommended as it can make a huge difference to finding that perfect balance between sleeping well at night while not 'leaving any money on the table'.
If a fund’s risk changes significantly, that fund must stop offering returns until the PDS has been updated because the current PDS can be considered false or misleading. It is not always that an update is necessary as the FMA has taken into consideration a reasonable range that allows for small oscillations but this phenomenon must be disclosed in the PDS in words such as “While risk indicators are usually relatively stable, they do shift from time to time. You can see the most-recent risk indicator in the latest fund update for this fund”. If the change is significant, the PDS must be updated to reflect this change before more interests are issued.
Notice must be given if the risk indicator has moved 2 or more categories in either direction.
Notice must also be given if the risk indicator has moved the fund to a new risk category due to a change in Investment policies as stated in the SIPO (Statement of Investment Policies and Objectives) - affected by the long term policies of the fund.
If the risk indicator is consistently inconsistent when compared to the risk indicator stated in the PDS. This depends on whether the fund needs to give quarterly or annual fund updates.
This is very much in line with what the CESR has also stated. It is important to set in place rules and standards of measure to avoid any change of risk classification caused purely due to errors in the pool sample of data or miscalculations.
Therefore, according to the CESR, to avoid a move due to calculation mistakes, a fund may be placed in a different risk category only if the volatility calculated in the next 4 months causes it to have a risk category that is different from the previous risk category it belonged to prior to these 4 months. In fact, New Zealand seems to be more lenient and allow for a longer period of testing before any changes are deemed necessary.
The reason being, as stated by the Committee of European Securities Regulators, that KIDs or PDSs are usually revised no more than once a year. Furthermore, they do not want funds to move across different risk scales very often as that might cause investors to be concerned about the reliability of the risk and reward indicator system.
The indicator is a tool used to calculate historical volatility. This gives investors a way of assessing and comparing the volatility of different funds.
It must not have a name that misrepresents the:
What this means is that funds names such as: Cash, Conservative, Moderate, Balanced, Growth, Aggressive, etc, must correspond with the correct level of risk (1-7). There must not be any confusion or misrepresentation happening between the fund name and the level of risk associated with it. For example, a fund, namely a Cash Fund must not display a 7 level of risk. Being the fund generally associated with the lowest level of risk, it would be highly misleading if it had the highest number of the Risk and Reward Indicator system associated with it.