Investor advocates disappointed with POS risk disclosure

The latest proposed changes to the Canadian Securities Administrators’ (CSA) point-of-sale (POS) disclosure rules — national instrument 81-101 — further diminish, rather than enhance, the usefulness of POS documents, an investor advocate group argues.

NI 81-101 is directly aimed at advisors who sell mutual funds. Under the new rule, advisors would be required to provide a two- to three-page Fund Facts document, which outlines the most crucial information that is usually found in a prospectus. Before investing in an advisor-recommended fund, the client would have to acknowledge that he or she has read the document.

POS disclosure has been a major issue of contention in the industry for more than a decade. It was a major plank of the work done by former Ontario Securities Commissioner Glorianne Stromberg in the late 1990s.

The Small Investor Protection Association (SIPA) submitted its comments to the CSA regarding proposed changes to NI 81-101, which were announced in June. There are a number of concerns that SIPA has run the gamut, from fee disclosure to appropriate benchmarking. The submission, which was authored by more than 30 members of the group, takes particular exception to the lack of risk disclosure. SIPA argues that investors are being shortchanged on receiving crucial information in the proposed Fund Facts document that pertains to risk.

Proposed risk disclosure changes Arguably, the most significant change in the latest proposal from June 19, 2009, is the elimination of using the Investment Fund Institute of Canada’s (IFIC) Fund Risk Classification Model to determine the downside risk potential of the fund — that is, the likelihood of losing the principal investment.

The IFIC risk measure is a scale from one to five, which managers fill in, based on their standard deviation of returns versus other funds in the same Canadian Investment Funds Standards Committee (CIFSC) group.

SIPA wasn’t happy with the risk disclosure to begin with — and it’s even more concerned that eliminating the only statistical measure of risk reduces the value of the Fund Facts document.

The new proposal will now require the manager of the mutual fund to provide a risk rating for each mutual fund based on the risk classification methodology adopted by that manager. The manager will then identify the mutual fund’s risk level on a scale prescribed in the form made up of five categories ranging from low to high.

“We recommend using the worst 12-month return if the fund has been around for at least 10 years. If not, we continue to suggest using the return of the corresponding CIFSC fund category, realizing that a number of risks such as political risk, securities lending risk or currency risk are not captured in a simple statistic,” SIPA’s submission states. “Some narrative should be permitted even if an additional page is required. It is, after all, the communication of risk and suitability that is at the heart of POS disclosure.”

Ken Kivenko, the chair of the advisory committee for SIPA, says risk disclosure should be the single most important aspect of the Fund Facts document, because it is the single biggest concern for the bulk of retail investors either in or fast-approaching retirement.

“Regulators have difficulty putting out rules that clearly enunciate risk. I can only assume the industry holds them back,” Kivenko says. “Using the [IFIC] sliding scale, some of the funds [listed] as moderate or conservative risk have dropped 35% to 40%. You cannot capture risk with other parameters such as beta, but you certainly can’t capture risk with a little scale like a thermometer.”

It was actually IFIC that railed against the use of its own risk measure, arguing that it simplifies an analysis of risk, which is directly related to client suitability. IFIC’s view of a proper risk analysis needs to be specifically tailored to an individual client — having a general measure of risk could mislead investors into thinking the fund matched their individual risk tolerance.

“Our risk classification scale was never meant as a substitute for suitability. It was never meant to be used as a sole determinate of whether a given fund is the right fund for an individual investor. That’s the role of a dealer firm, which would look at the customer’s risk tolerance, his or her investment objectives and his or her financial situation in determining if a product was suitable,” says John Cockerline, director of policy-dealer issues with IFIC. “The dealer and advisor would look to the prospectus to ensure that particular fund was the right one for their client. We recommend that process not be shortened or oversimplified for the benefit of investors.”

SIPA is concerned that there is no way to ensure that advisors and clients are adequately discussing risk. According to SIPA, under the POS rules, the Fund Facts document can be emailed.

“The electronic delivery option can be met by merely providing an email link to the document as well as by emailing the document itself. No documentation regarding proof of delivery is required to be maintained by the firm. (A Read Receipt could be requested and retained as evidence of transmittal.),” SIPA writes. “We do not believe that making information available to clients on a website is equivalent to delivering the document in paper or electronic form, as it is demonstrably not as effective in bringing the information to the attention of the client.”

SIPA says email has no value if you cannot determine that an advisor-client discussion about risk and client suitability took place.

“To us, this mechanization by email of a critically important disclosure seriously negates its value. It effectively amounts to access equals disclosure. No client-adviser discussion on costs, risks or suitability, just the mechanical transmission of an important document to fulfill a regulatory obligation. The central idea of investor-salesperson interaction seems to have been lost.”

(08/26/09)