**Fund Facts – more tweaking needed**

Fund Facts is a new four page document that must be given to a new or existing mutual fund investor prior to purchase.

It is meant to be a short and relatively easy to understand information document about the fund you are buying. Its purpose is to ensure that the buyer can make an informed decision when considering the purchase of a particular mutual fund.

Fund Facts was launched mid-2014. Now that advisors and investors have had some time to familiarize themselves with it, it’s time to look at it with a more critical eye and see whether there is room for improvement.

Although I was initially enthused about the use of a graphical risk ruler as a simple and straightforward measure of “riskiness”, some investor groups have criticized the usage of such a ruler as misleading. The graphical ruler describes a fund on a sliding scale as low, medium or high risk. Their view is that the underlying methodology (standard deviation) is faulty and should not be used.

I do see their point.

Although standard deviation is the basis for statistics and probability theory, its use as a measure of risk is currently in the middle of a raging debate. Theorists indicate that “outliers” near the tails of the conventional probability distributions are perhaps more frequent, and mathematics should account for these occurrences. Now, my background in 1970s mathematics is a bit hazy so I won’t argue as to whether or not we should replace Fourier transforms for Laplace; however, some academics are suggesting doing away with bell distribution curves completely.

Critics of the Fund Facts graphical risk ruler point out that standard deviation measures a too short period of time – perhaps as little as 5 years or less. Since standard deviation is really a measure of up and down fluctuations, you could, theoretically speaking, have an investment that is smoothly declining to zero. In this case, because there is no zigging and zagging (no fluctuation), the graphical ruler could indicate a “low risk” fund. To carry the argument to an extreme, you could market the world’s worst investment as a low risk, low volatility fund!

If we are stuck with using standard deviation and graphical risk rulers, what should advisors do?

I am careful to point out to investors that the ruler is strictly a measure of short-term fluctuation.

Are there better risk adjusted return formulas out there? Most likely there are, but I still like the graphical elements of graphs and rulers, and as an interim step, the measurement periods should be extended to at least a decade. Alternatively, we could have two or more standard deviations: 5 year, 10 year and since inception numbers.

Since we are talking about time periods, one measurement in the new Fund Facts document stands out (in a bad way). As a possible replacement for standard deviation measurements, I think that the maximum drawdown should be published. It is published now but only for the worst 3 month period. That is far too short of a timeframe! To really indicate the “riskiness” of an investment, we should know the maximum drawdown in percent over any period. As an illustration, most investors who consider an index-based fund would be staggered to know that the maximum drawdown for the S&P 500 index is an astonishing -56%[1]. And no, that not a hyphen in front of that 56!

Investors have already forgotten that the stock market dropped 56% from October 2007 to March 2009. For the “passive-ist” investors out there who prefer indexing over active management: are you prepared for that type of volatility? Maximum drawdown numbers, without a doubt, snaps you back to reality pretty quick.

All-in-all, Fund Facts is a great step in the right direction. Advisors and clients that I have spoken with are relieved that they no longer have to deal with a 250 page prospectus* now that a concise, four page document will do the job.

Still, the Fund Facts document is not perfect and it needs to be improved on a continuous basis.

*The more detailed but far thicker prospectus has not been eliminated by the Fund Facts document. It is still available on request.

[1] http://www.advisorperspectives.com/dshort/charts/markets/SPX-snapshot.html?SPX-snapshot.png