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Daunting task in EU risk rating system

Cautious managed funds could feature the exact same risk rating as those in the Japanese equity or even in the smaller companies sectors under planned EU rule changes to all Ucits funds. This risk rating will be graphically featured in the two-page document that advisers present to clients, called the key investor information, from July 2012.

For years, the FSA has attempted to create a risk-rating system for retail funds but coming to an agreed definition of risk has always been a stumbling block.

Even the US gave up on this. Not so for the EU’s committee of European securities regulators. It has decided that all EU member states will use five-year historic volatility figures as a basis to create seven numerical risk categories, ranging from “lower risk (with typically lower rewards) to higher risk (with typically higher rewards).” This is displayed using a visual sliding indicator.

The number given to a fund is featured under the KII’s risk and reward section, even though it is based solely on historic volatility.

The wording in this section leaves investors open to the assumption that the more volatile a fund is, it is likely to feature higher rewards. As many advisers would agree – that is not quite so.

’If the UK decides to define different boundaries for the seven risk ratings, then our funds will not be comparable with foreign Ucits funds domiciled elsewhere. We are between a rock and hard place here’

There is a performance section in the KII but, as the IMA points out, that is not without issues either.

For one, it allows a fund which has materially changed its mandate to use the old mandate’s track record.

It also gives providers the option to select which track record they want to preserve in the case of a fund merger. Currently, the retention of a track record in the case of fund mergers is dependent on many factors but, under the CESR rule changes, it comes down to one thing only – which is the receiving fund from a legal sense.

But those concerns aside, it is the risk rating that poses the biggest issues for advisers and their clients.

Both the IMA and Legal & General, in their submissions to CESR, pointed out the risk classification system does not adequately enable investors to distinguish between different funds.

IMA director of authorised funds and tax Julie Patterson says that, under the system, 85 per cent of all UKauthorised funds would fall under a rating of category five or six. That is to say they would have volatility scores of more than 10 per cent but less than 25 per cent. As such, an investment grade corporate bond fund could have the exact same score as say a UK equity portfolio. And that is not even taking into consideration the wide variance already seen among UK equity funds alone. Should a highgrowth or momentum manager have a similar risk rating to a fund in the equity income sector? Under CESR rules, they may.

Patterson said the IMA did not find any fund that would receive a risk score of one but said a small number were classed as two or three on CESR’s risk scale, mostly gilt funds.

Another key concern is that the visual representation of this risk rating will far outweigh the printed text in the minds of investors, leaving it up to the adviser to fill in the gaps and seek additional literature.

CESR’s templated KII has a section for two explanations to accompany the risk score. One covers fairly standard elements such as the fact the risk category is not guaranteed. However, the other includes an explanation of credit, liquidity, counterparty and operational risks as well as any impact from techniques such as derivatives.

According to the EU rules, providers must use a font size of between 10 and 11 points to cover these points. That leaves space for fewer than 200 words to describe all of these individual points.

Companies must also use everyday language to cover these risk points so it is unlikely that “counterparty” itself is an accepted word.

There is one loophole to which UK providers are likely to avail themselves. CESR has conceded that companies can take the font size down to eight points if they use newspaper-type columns in the document’s format. Patterson believes this is what many providers are likely to do, which means a return of the small print. Patterson noted despite the concerns raised in a consultation that only just ended, there is little hope that anything will change ahead of July 2011 when the EU initiative comes into force – although product providers have until July 2012 to adhere to the rule.

She said: “The only thing not a EU rule is the methodology underlying the risk numbers. But if the UK decides to define different boundaries for the seven risk ratings, then our funds will not be comparable with foreign Ucits funds domiciled elsewhere. We are between a rock and hard place here.”

The FSA is expected to issue its consultation paper on the implementation of the KII at the end of next month.

Another key concern for groups, which will have a significant knock-on effect for advisers, is the sheer work load this creates for providers.

Each share class of every sub-fund must feature a KII and that is not including all the various languages it must be done in for all the regions in which that fund is available. Potentially, that means that just one fund could have more than a dozen different KIIs.

These must all be updated annually – exactly 35 days after the start of the new year. The risk rating each contains must be monitored weekly throughout the year. If at any point the risk rating of a fund is outside its existing categorisation for four months, a new KII must be issued with the new rating.

Kii Hub head of marketing Mikkel Bates says: “The aims of KIIs are generally applauded in principle but are already creating huge challenges in practice.
“For example, explaining specific find risks in a few ’non-technical’ words alongside a standardised score is going to take some effort, to say the least.

“Add to that, rewriting every fund objective in simple terms, producing a KII for every share class and translating them into the language of every EU country where the funds are sold and the task becomes extremely daunting.”

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  1. I presume K11 will be printed & distributed in Latvian in order to make it absolutely clear

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