BARRA Offers SEC Recommendations on Standard Mutual Fund Risk Disclosure; Risk Analysis Based on Current Portfolio Holdings Allows for Changes in Market Conditions, Fund Leadership and Holdings

Business Wire, Sept 11, 1995

(NASDAQ:BARZ) the leading provider of analytical software, data and services to the worldwide investment community, urged the U.S. Securities and Exchange Commission (SEC) to establish a reporting standard that will allow investors to make "real time assessments" of mutual fund risks.

In a "white paper" submitted in response to the SEC's request for input, BARRA Research Director Ronald Kahn urged the adoption of standard deviation, which measures volatility of a fund's returns, as the standard definition of risk. This would result in measurements that investors could use to compare the risk different funds take in order to produce certain levels of returns.

Going a step further, he said risk measurements should be based not simply on a fund's historical performance, but rather on an analysis of its current portfolio.

"When you analyze a fund's historical results, it's like looking in a rear-view mirror," Kahn said. "You can see where the fund has been in the past, but you can't tell where it is now. And there can be a big difference."

"But, by basing risk analysis on a fund's current portfolio of securities," he explained, "it is possible to provide investors with real-time assessments of how much risk that fund is taking currently. The technology is available to implement such a system, and it would be enormously more useful to investors."

Spurred by the unprecedented losses among bond funds last year, the SEC is considering supplementing mutual fund disclosure requirements to include additional information measuring their relative degrees of risk. While mutual funds are currently required to disclose information on past returns in a standard way, there are no industry-wide requirements for assessing or disclosing information on risk. Investors, however, frequently assume that certain categories of funds may have less risk than others; for example short-term vs. long-term bond funds or "balanced" vs. aggressive growth stock funds. This may or may not be true.

"In evaluating a mutual fund, return is only one side of the equation," Kahn said. "You also have to examine risk, or the probability of returns varying from their average levels. Every individual has their own threshold of risk, and individual investors already take risk into account when deciding between types of investments, such as a stock fund or a bond fund. But we need to go beyond that and let them compare different stock funds and bond funds to each other."

All definitions of risk arise from the probability distributions of possible returns, but this information is too complicated and detailed to be used in its entirety. BARRA's white paper urges that any standard definition of risk be captured in a single summary number. Although the use of a single number has its drawbacks, it is the most practical approach for guiding the majority of investors.

The white paper examines several proposed risk definitions including standard deviation; semivariance/downside risk; shortfall probability and value at risk. BARRA recommends adoption of standard deviation, which measures the uncertainty of the returns, or volatility. Econometricians have developed powerful tools for accurately analyzing standard deviation, which is the accepted definition of risk in the institutional investment community .

BARRA recommends an approach based on risk analysis of current investments. The great advantage of this approach is that it provides exact analysis of the current portfolio, accounting for changing market conditions, with no assumptions about constancy of portfolios over time, unlike risk analysis of past returns. Although the analysis of historical risk vs. return can be valuable in understanding past performance, current portfolio risk is a much more appropriate method for evaluating risk when selecting a mutual fund.

Analysis of current portfolio holdings requires more data, specifically, the exact portfolio holdings, and use of sophisticated analytical software. But such software is now available from BARRA and other vendors and in the long run, as institutional investors have come to realize, the benefits greatly outweigh the costs.

BARRA's recommendations stem from a historical overview of risk analysis in the investment community and an in-depth examination of the advantages and disadvantages of three major approaches to mutual fund risk for individual investors. Risk analysis has been central to investing since the 1950s, and advances in computer technology and risk modeling have made it a useful tool for institutional investors in the past 20 years. But this knowledge has not yet been made readily accessible to individual investors.

"The huge losses in bond funds last year took a lot of individual investors by surprise. With the total assets of all mutual funds now in the neighborhood of $2.5 trillion, the SEC has recognized that mutual fund investors, who are often not Wall Street experts, need more easily accessible information on these investments," said Kahn. Since their March 1995 request for input, the SEC has received a record number of more than 1,500 comments on this issue.