New MF Riskometer – Because what you see is not what you get!

You open any mutual fund analysis report or fact sheet and the risk-o-meter stares at you. Risk-o-meter is a graphic representation of which bucket of risk the fund falls into.

Oct 22, 2020 08:10 IST India Infoline News Service

SEBI recently changed the definition and methodology of mutual funds presenting the risk-o-meter to make it more meaningful. Firstly, what exactly is the risk-o-meter?You open any mutual fund analysis report or fact sheet and the risk-o-meter stares at you. Risk-o-meter is a graphic representation of which bucket of risk the fund falls into.  Here is how a typical risk-o-meter of a mutual fund looks like today.

The explanation is fairly straight forward but this is a more elegant representation. Each of the five buckets has a certain implication and certain fund classes would automatically fall into these categories. Consider the table below which explains such a classification.

Low Risk Moderately Low Risk Moderate Risk Moderately High Risk High Risk
Liquid Funds, money market funds Short term, ultra short term and debt funds Arbitrage funds and debt oriented hybrid funds Large cap funds and equity oriented hybrid funds Sectoral Funds and thematic funds

In short, if it was a liquid fund the arrow would point to low risk and if it was a pharma or IT fund then the arrow would automatically point to high risk. That was OK, till the time every fund followed the definition strictly and to the book. But that is not what happens. For example, debt funds had large exposures to unlisted debt. Many short duration funds had exposure to credit risk. Then there were smaller equity funds where the thematic risk was too high and they were not diversified in the strict sense. In such cases, the traditional risk-o-meter would be grossly inadequate. That is why SEBI has come up with a more dynamic risk-o-meter.

What the new MF risk-o-meter is all about?

In the light of the recent incidents, especially with respect to debt funds, SEBI has overhauled the product labelling guidelines to give a better picture of the risks associated with each fund.  Here is what has changed about the new risk-o-meter.

• SEBI has made a long needed change and shifted the risk-o-meter from a static measure to a dynamic measure. In the new dispensation, the risk-o-meter will also reflect any underlying change in the portfolio composition of the fund.

• Now fund managers will have to proactively communicate to unit holders if the risk level of a fund changes. Remember, the onus is now on the AMC and the fund manager to ensure that such a communication happens.

• To ensure that the risk-o-meter is actually dynamic, SEBI has stipulated that each fund will have to be evaluated on a monthly basis and based on the changes in the underlying portfolio, the risk classification may have to also change.

• In the current risk-o-meter set-up, there are only 5 levels of risks to be displayed as captured in the graphic above. Now, the risk-o-meter will display one more notch of “very high risk” to caution investors.

• SEBI has also standardized the methodology to assign these risk-o-meter ratings. For example, the methodology will include liquidity risk, interest rate risk and credit risk in the case of debt funds. Even within categories, risk ranks will go from 1 to 12.

• The final weight will be weighed by AUM and the justification is that risk in funds with higher AUM is a lot more significant than funds with low AUMs as there is more of investor money at stake.

• A similar granular approach has been adopted in the case of equities too. For example, equity fund category ranks will also progressively increase with risk. For example, large cap stocks will be assigned a value of (5), mid caps (7) and small caps (9).

• It needs to be remembered that these modified ranking template will go live from January 01, 2021 so all the AMCs will have to be ready with the requisite methodology at the back end include the process flow to communicate changes to investors.

• The advantage going ahead will be that investors and advisors will have a much simpler task on hand. They need to just take a fund and compare the risk-o-meter classification of the fund over the last few months and the risk profile is crystal clear.

Why the shift is significant for investors?

This shift in the risk-o-meter methodology is significant for the investors and advisors in three ways. Firstly, it puts the onus on the fund to ensure that the portfolio reflects the risk basket it is classified into. As we learnt the hard way, a short duration fund investing in credit risk is a recipe for disaster.

Secondly, this methodology gives the highest weightage to liquidity. Most retail investors in debt funds do not appreciate the importance of this risk. When markets get illiquid, even liquid funds can generate negative returns. Lastly, mutual fund factsheets will finally become actionable rather than just report on performance. Transparency has never harmed financial markets, and this time it will be no different!

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