Mutual Funds

How to read the new mutual fund risk-o-meter

Aarati Krishnan | Updated on January 16, 2021

Most AMCs have been sending out cryptic e-mails. We tell you how to read between the lines

In the past couple of weeks, inboxes of Indian mutual fund investors have been flooded by e-mails from fund houses alerting them to changes in risk-o-meter classifications. These mails have been prompted by a October 2020 SEBI circular which asked fund houses to redo the risk classifications of their schemes, based on a standard set of quantitative metrics.

But with most AMCs sending out cryptic e-mails on how your schemes’ risk-o-meter has changed without explaining much, the exercise has given rise to many investor queries. We address the key ones here.

I’ve never paid much attention to the risk-o-meter of my MFs. Why am I getting these mailers now and how should I interpret them?

SEBI had originally introduced the risk-o-meter in fund ads and documents to visually alert investors to the risk profile of the schemes. Until January 1, 2021, AMCs decided on the risk classification for schemes based on the categories they belonged to.

So, an ultra-short-duration fund across AMCs, irrespective of the quality of its portfolio, was low risk, an index fund was moderately high risk, and a mid-cap fund high risk.

But recent mishaps in the industry have prompted SEBI to review this blanket approach. AMCs now need to do a risk-profiling of their schemes based on an assessment of individual portfolios. The new risk-o-meter can help you gauge if a fund house is running equity or debt schemes with a higher risk profile than peers. It also tells you how much risk of capital loss you are exposed to with each scheme.

One AMC has classified its gilt fund, corporate bond fund, ultra-short fund and money market fund, all as moderate risk. Weren’t gilt and money market funds safer than schemes investing in corporate debt?

Gilt funds may carry no default risk like corporate bond funds, but they do carry the risk of losses from interest-rate increases. When assessing the risks in debt funds, the new SEBI rules require fund houses to assign equal weights to three kinds of risks — credit risk (based on the ratings of bonds in the portfolio), interest-rate risk (Macaulay duration of the bonds) and liquidity risk (whether the bonds are listed and specially structured). Each bond in the portfolio is scored on its credit rating, duration and liquidity to arrive at overall scores for credit, interest rate and liquidity risk. Then, all three factors are given equal weight to arrive at risk classification.

But the liquidity factor is given extra heft. If a scheme’s liquidity risk score is higher than the average of all three parameters, it will be ranked on the liquidity risk score alone.

I preferred index funds over actively managed funds because I thought they carried lower risk. Why are they lumped together with active funds and ranked very high risk. Mid- and large-cap funds are in the same risk bucket?

This tells you that index funds, too, can lead to capital losses, just like actively managed funds. When arriving at the risk grades of equity schemes, fund houses are required to consider three factors — market-cap of stocks in the portfolio, daily volatility in their prices and impact costs.

In market-cap scores, large-caps receive far lower risk scores than mid- or small-caps. Stocks with more than 1 per cent daily volatility and 1-2 per cent impact costs are ranked higher on risk. A scheme’s total scores on all three factors are averaged to arrive at its overall risk score.

If this total risk score is above 5, a scheme is ‘very high risk’. So a scheme scoring 9 and another with 6 are both very high risk.

I own a value fund with investments in overseas stocks. It’s surprising to find it ranked ‘very high risk’...

That could be because, as per SEBI rules, foreign shares or foreign MFs attract a high-risk score (7), the same as mid-cap stocks.

What are some of the risks in funds that are not reflected in the new risk-o-meter?

In both equity and debt, a scheme’s portfolio concentration is not considered. However, a scheme that holds high weights in its top stocks or bonds is certainly riskier than one that holds smaller weights.

In equity schemes, a higher portfolio valuation (price-earnings ratio), a higher proportion of cyclical companies, or companies with weak business metrics will add to portfolio risk, but these are not captured in the risk-o-meter. High daily volatility and impact costs are considered risks, but these may not be big considerations for long-term investors.

So, it looks like I cannot simply go by the risk-o-meter and must do a deep-dive into the portfolios of my schemes to gauge their true risk.

Absolutely right!

Published on January 16, 2021

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