Risk Rating

OBSI's approach to risk rating of securities and portfolios

Risk rating of securities is a key component of suitability analysis

As part of OBSI investigations, we often need to assess the suitability of a complainant's investments. To do so, we follow industry-accepted principles and best practices to compare an investor's needs and circumstances to the risks and characteristics of their investments and investment strategies. This document provides a high-level explanation of our approach to investment risk assessment in general and outlines the types of information we consider and analyze for several common asset types.

How we assess investment characteristics and risks

OBSI independently assesses the risk of individual securities as well as investment accounts and portfolios and how the risk profile changes over time. In a typical case, our analysis has two major phases:

1. Information gathering and independent analysis of the risk of each security in an account and portfolio
2. Assessment of the aggregate account or portfolio risk

We outline below in greater detail what is involved in each phase of our analysis.

Phase 1: Information gathering and risk analysis of each security

We start by collecting and considering a broad range of information about each security at the time(s) they were recommended to an investor and at regular time intervals as they continued to hold the security.

The determination of the regular time intervals will depend on the level of trading activity in the account or portfolio. Monthly or quarterly intervals are used when there is a lot of trading activity, while semi-annual or annual intervals are used when there is a limited amount of trading activity.

Equities

When assessing equity risk, we begin with the analysis of the issuer's financial statements to understand its current and past profitability, financial position and cash flows^[1]. We also examine the firm's market data to assess its financial ratios relative to its industry/peer groups (e.g., price to earnings, earnings per share, cash flow yield, debt to equity, profit margins, etc.), dividend payment history (if applicable), market capitalization and liquidity, and its trading history including beta and price volatility (standard deviation).

While quantitative financial criteria are of primary importance in the risk ratings of securities, qualitative factors can also be important components of the overall risk assessment. To analyse these factors, we conduct an assessment of all other relevant sources of financial, industry and operational risk^[2], including the issuer's:  

• industry sector(s), product lines, competitive position and economic outlook
• business model (including whether it is a private or public company)
• lifecycle stage (i.e., start up, rapid growth, mature, decline)
• corporate governance
• regulatory filings such as offering documentation, annual reports, MD&A (particularly the stated risks in the MD&A section)
• significant news releases, corporate, market, social or economic events

During this phase, we will also consider the analysis of other industry professionals, including historical analyst reports (where appropriate), consensus ratings (if any), and any analysis conducted by the firm and/or advisor, particularly any analysis conducted at the time of investment recommendations. We may incorporate these factors or use assessment techniques presented by the firm and/or advisor where we find that such factors or assessment techniques were reasonable and appropriate in all of the circumstances of the case.

Based on this analysis, we will form a view of the risk rating for each equity at each relevant point in time.

Fixed income

When assessing the risk of fixed income securities, we focus our analysis on the issuer's credit risk. Credit risk is defined as the risk of loss resulting from an issuer failing to make full and timely payments of interest and/or principal and takes into account both default risk and loss severity in the event of a default^[3]. To determine an issuer's credit risk, OBSI considers several factors including:

• issuer credit rating(s)^[4] published by the major credit rating agencies, if available
• the issuer type (e.g., government, quasi-government organization such as a crown corporation, or a corporation)
• the industry sector and the nature of the issuer's business, if applicable
• key financial credit measures, such as profitability, leverage and interest coverage
• whether the debt is secured or unsecured. If secured, the nature of the security will be considered
• the debt seniority or ranking in relation to the company's other debt obligations
• the term to maturity
• the yield and how it relates to benchmark yields (referred to as spread risk)
• the issuer's interest payment history
• the market for the issue and its liquidity
• reasonable analysis from other industry professionals, including the firm and/or advisor's contemporaneous analysis

Mutual funds

When assessing mutual funds, OBSI generally relies on the risk ratings published in the mutual fund company's simplified prospectus or fund facts document.

Phase 2: Assessing the risk profile of the account or portfolio and any changes over time

Next, using the risk ratings determined in the first phase of analysis, we will assess the risk profile of an account or portfolio and compare it against the investor's investment objectives, risk tolerance and personal and financial circumstances.

This assessment will include an analysis of additional risk factors, such as the account's diversification and asset allocation, as well as the risks of any accompanying strategy, such as active trading strategies or the use of margin or leverage. We will also consider how the risk of an account or investment portfolio changed over time as a result of trading activity, changes in a security issuer's circumstances and/or economic or market developments during the relevant investment period.

Sometimes a firm or advisor informs us they combined low-risk and high-risk securities to achieve a medium-risk portfolio profile. In these instances, we will ask for supporting documents and analysis (such as an asset allocation plan or a correlation analysis) to show that the combination of investments at various risk levels did in fact achieve a medium-risk profile for the overall portfolio. In practice, we have found that the risk characteristics of high-risk investments with respect to volatility and magnitude of total loss are usually much higher relative to the profile of medium and low-risk securities, and consequently such "risk offsetting" is difficult to achieve.

Questions?

Should you have more questions about our risk rating process, feel free to contact us.

In addition, you can find detailed information about the other components of our investment suitability and loss assessment process in our Consultation Paper: Suitability and Loss Assessment Process and in Our Approaches section of our website.