Warning over risk rating updates

Routine updates to statutory risk scores could mislead investors into believing certain funds have become a less risky proposition when actually they have not changed, experts have warned.

The numeric risk scores appear on key investor information documents (Kiids), which investors now have to declare they have read before they can buy a fund.

The synthetic risk-reward indicators (SRRIs), introduced in 2012 by European regulators as part of Ucits IV fund rules, rate funds on a scale of 1 to 7 based on five years’ worth of weekly volatility data.

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But experts have said that the most recent revisions to SRRI scores were flawed because they were excluding the bear markets that occurred during the credit crunch, which took place just over five years ago.

Investment Adviser has identified nine of the UK’s largest retail funds that have already been affected by the change, in spite of no alterations to their strategies or investment processes.

The funds have all seen their SRRI ratings reduced by one notch, implying that investors should expect a lower level of volatility. Groups confirmed to Investment Adviser last week that there had been no strategy changes in the past five years that would affect expected volatility.

The FTSE 100 index’s volatility registered 15.6 per cent in the five years to May 2, according to FE Analytics. In the five years to the start of May 2012, when the SRRI was first introduced, the FTSE 100’s volatility was 23.4 per cent.

Anthony McDonald, senior investment analyst at The Adviser Centre, said the research – combined with findings from the newly launched fund research group – showed inherent flaws in the calculation.

“If the regulator’s mandated risk measure is lower because of the environment, it’s implying funds are lower risk when the opposite is true,” he said.

He argued that the SRRI’s approach also implied that stockmarkets become less risky when they have risen for a prolonged period.

“Five years is not a particularly long time to make an investment decision, and this period is really not based on a full cycle,” said Mr McDonald.

He added that equity funds could experience a “wholesale shift down” in their SRRI ratings as a large number are near the “cut-off point” between one rating and the next.

Andrew Alexander, head of investments and product strategy at advice firm Three Counties, said: “If a fund’s process has not altered, surely it means that the [SRRI] risk banding needs to remain the same. But if not, then that is a bit of a shocker.”

Fund management trade bodies hinted that the SRRI may be revisited in future discussions of Ucits rules or during debates over the wider-ranging Packaged Retail Investment Products directive, which aims to roll out Kiids for other savings products.

Jarkko Syyrilä, deputy director-general of the European Fund and Asset Management Association, said the SRRI should not be used on its own as an indication of risk as it “doesn’t give the full picture”.