Prudent Testing Framework of Mutual Funds Before Offering by The Risk Scoring Method

Abstract

One of the primary responsibilities of asset management companies (AMCs) before offering various mutual funds to investors is product testing, as mandated by the Securities and Exchange Commission (SEC). This crucial step involves evaluating the risk levels of mutual funds under hypothetical scenarios, such as crises affecting the prices or liquidity of the fund’s assets. However, the SEC does not prescribe specific risk factors for testing, leading to diverse assessment methodologies based on evaluators' individual experiences. This inconsistency impedes effective risk comparison across similar mutual funds within AMCs. The goal of this research is to construct a standardized methodology for mutual fund product testing through the systematic scoring of risk factors, providing AMCs with a universally recognized framework for risk assessment. The methodology is demonstrated by evaluating the risk factors for the equity fund, iShares Russell 2000 ETF and the fixed income fund, X-Plus, both intended for future offering. The Value-at-Risk at 95% confidence level (VaR 95%)  is employed to measure market risk, while Expected Loss (EL) is utilized to gauge credit risk. Additional performance metrics, including Tracking Error, Sharpe Ratio, and % Daily Win Rate, are also incorporated into the evaluation. By converting each factor into a specified risk score and aggregating these scores, the study determines that the equity fund possesses a "moderate" risk level, whereas the fixed income fund exhibits a "relatively low" risk level. These findings align with the statistical performance data of similar previously offered funds. Consequently, the research concludes that the developed risk assessment methodology and specified risk factors can effectively serve as a benchmark for evaluating the risks of similar mutual fund types in future offerings, ensuring consistent and unbiased assessments irrespective of individual evaluators' experiences.