Industry groups propose new risk scale for alternatives

As new rules take effect that will open up the alternative investment fund space to retail investors, a pair of industry trade groups is proposing a new risk rating system that leans against the tendency to classify alternative investments as inherently risky.

The Alternative Investment Management Association (AIMA) and the CAIA Association, which administers the Chartered Alternative Investment Analyst (CAIA) designation, issued a paper on Tuesday that sets out a proposed approach to providing risk ratings on alternative investment funds and strategies. The proposed new system aims to “reduce the complexity of current methods of risk ratings” by investment dealers, which, the groups say, often result in rating all alternative funds as high risk for retail investors. “This limits the number of investors who can access these products,” they say.

According to the paper, risk rating guidelines, which were introduced by the Canadian Securities Administrators (CSA) in 2017 based on standard deviation are “adequate for most traditional long-only strategies but may understate the risk in alternative investment strategies, which tend to have ‘fat tail’ risk events.” This can create confusion for dealers and advisors, particularly as dealers layer on their own risk rating policies on top of the CSA guidelines, the groups say.

“For instance, many alternative investment strategies (e.g., market neutral equity and relative value fixed income) have low return volatility, which may result in a low risk rating. This result may cause confusion at distribution channels as money market funds are also rated low risk,” the paper notes. “To add to the confusion, many distribution channels have only three risk rating categories (low, medium and high), as opposed to the five under the CSA framework.”

Among other things, the paper calls on investment dealers to re-evaluate their risk rating systems for alternative fund strategies, including alternative mutual funds, to capture their true riskiness. It recommends that dealers adopt five standardized risk categories, and that risk ratings be based on the median trailing standard deviation of funds within indices.

“AIMA Canada and CAIA’s Risk Rating Guideline seeks to eliminate barriers to distribution by more fairly aligning risk ratings with true risk based on the specific type of alternative strategy and qualitative due diligence on the manager and product. We advocate a review of risk rating systems by investment dealers for all alternative strategies and the use of a five-tier risk scale (rather than only three) for greater flexibility, improved accuracy and consistency with prospectus risk ratings,” said Belle Kaura, chairwoman of AIMA Canada.

Under the proposed rating system, no alternative strategies would be rated “low” or “high” risk. The riskiest strategies would be long-only equity and emerging markets, which would be rated “medium to high.” Market-neutral equity, long-short credit, multi-strategy and relative value arbitrage strategies would be considered “low to medium,” while equity long-short, global macro, CTA/futures, and event-driven strategies would be rated as “medium” risk.

“Alternative investments play a key role in a balanced portfolio, offering diversification, risk reduction and non-correlated returns to investors. It is imperative, especially late in the economic cycle amid a rising rate environment, that Canadian investors are not denied access to the benefits of alternative strategies by simplistic and unfair methods that rate all alternative investments as high risk,” Kaura added.

“Canadian investors deserve a fair opportunity to access the talent and strategies managed at boutique and established investment firms without requiring an unjustly high-risk investing profile to do so,” said Claire Van Wyk-Allan, director and head of AIMA Canada.

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