How mutual funds risk-o-meter will work: Explained

new riskometer

In a movement that will help investors to make a more informed investment decision, the capital markets index Securities and Exchange Board of India (SEBI) has made it mandatory for mutual funds to select a risk level to schemes, based on certain parameters.

SEBI’s ruling on the “risk-o-meter”, which it announced on October 5, 2020, came into effect on January 1. In its round issued on October 5, the regulator made it necessary for mutual fund houses to characterize the risk level of their schemes on a six-stage scale of “Low” to “Very High”.

How will the risk-o-meter work?

As per the October 5 circular, all mutual supplies shall beginning January 1, assign a risk level to their plans at the time of launch, based on the scheme’s characteristics.

The risk-o-meter must be decided every month. Fund houses are required to disclose the risko-o-meter risk level along with the container disclosure for all their schemes on their own websites as well as the website of the Association of Mutual Funds in India (AMFI) within 10 days of the close of each month.

Any change in the risk-o-meter treatment with regard to a scheme shall be communicated to the unit-holders of that system, SEBI has said.

How is this distinct from the older category risk level?

There has been a kind of risk-o-meter for mutual stores since 2015; however, the schemes simply showed the danger level of the category that they belonged to. They did not reflect the riskiness of different schemes and their respective portfolios.

Therefore, all large-cap schemes — or any other class of schemes — across fund houses, carried the same risk level (one of five risks levels) that was allowed by SEBI to the category to which they belonged.

This has changed with impact from January 1 this year. Fund houses must now assign a risk level out of six possible levels — the “Very High” category is new — after determining their risk value from their respective portfolios.

Since the risk assessment and risk levels would be arrived at after taking into account critical parameters such as credit risk, discount rate risk, and liquidity risk in case of a debt plan, and parameters such as market capitalization, volatility, and influence cost in case of an equity scheme, industry experts feel that the risk-o-meter will now present a more objective assessment of the riskiness of a special scheme to potential investors.

Many feel that the earlier section risk-o-meter was in a way misleading — the category risk-o-meter had no contact with the schemes, and two schemes of two different fund houses in the same kind would reflect the same risk level, even though they had very complex portfolios and riskiness profiles.

Now, if in the same class, one scheme is generating a higher return than others, investors will be able to think out if it is, in fact, taking higher risk than others for generating these higher returns. In effect, this adds another layer of information to make an advance decision.

How will the level of risk be charged?

Which one of the six risk levels — low, low to medium, medium, moderately high, high, and very high — would apply, would depend upon the risk assessment (less than 1 for low risk to more than 5 for very high risk) calculated for the scheme. So if the risk assessment of a scheme is less than 1, its risk level would be low, and if it is more than 5, the risk will be very important on the risk-o-meter.

How will the risk value be calculated?

For an equity portfolio, the risk value would be a pure average of market capitalisation value, volatility value, and impact cost value.

While the market cap rate of a portfolio will be based on the weighted average of the market capitalisation values of each contract (5 for large-cap, 7 for mid-cap, and 9 for small-cap), the volatilization risk value of the portfolio will be the weighted average of the volatility value of each security (5 for daily volatility of up to 1, and 6 for more prominent than 1).

As for impact cost value, which is a measure of liquidity, the value would be the weighted average of impact cost advantages of each security (5 in case of average monthly impact value of up to 1; 7 for that between 1 and 2; and 9 for that above 2.

The risk value for the debt portfolio would be a mere average of credit risk value, interest rate risk assessment, and liquidity risk value. However, if the liquidity risk value is more important than the average credit risk value, liquidity risk value, and interest rate uncertainty value, then the value of liquidity risk shall be regarded as the risk value of the debt portfolio.

While the credit risk value of the portfolio would be designated 1 for AAA-rated and 12 for tools below investment grade, the investment rate risk will be valued using the Macaulay Duration of the engagement (1 for duration below 0.5 years and 6 for those with the duration of over 4 years). (Macaulay Duration is the weighted normal time for which a bond has to be held in order that the total existing value of cash flows received matches the current market value paid for the bond.)