New Mutual fund ‘Risk-o-Meter’ (2020) by SEBI

SEBI has revamped the mutual fund Risk-O-Meter (or Riskometer) via a new circular in October 2020 (link or download here). This time, the regulator has provided detailed guidelines for deciding the place of each mutual fund scheme on the Riskometer.

What is Risk-o-meter for mutual funds?

The Risk-O-Meter is a pictorial chart that depicts the risk of mutual fund schemes.

Under this new Risk-o-meter, now there will be 6 levels (categories) of risk for mutual funds schemes. These are as follows:

• Low Risk
• Low to Moderate Risk
• Moderate Risk
• Moderately High Risk
• High Risk and
• Very High Risk

Here is how it will look pictorially:

Earlier, there were just 5 categories. The additional ‘Very High’ Risk category has been introduced in this revamp.

The revised guidelines for the new risk-o-meter tool will have to be adopted latest by 1st January 2021.

The Risk-o-meter will be evaluated on a monthly basis and Mutual Funds/AMCs will have to disclose the Risk-o-meter along with appropriate portfolio disclosures for all their schemes on their respective website and on the AMFI website within 10 days from the close of each month. The fund houses will also have to disclose the risk level of schemes as of 31st March 31 every year, along with the number of times the risk level has changed over the year. That is, funds will have to track and publish the history of scheme Riskometer changes every year.

Any changes in Riskometer for a particular scheme will have to be mandatorily communicated to the existing investors. But it is important to note that any change in a scheme’s risk-o-meter won’t be considered a change in the fundamental attribute of a scheme.

Apart from the introduction of the 6th Risk level of ‘Very High’, the new framework takes a more comprehensive and detailed look at the scheme portfolio to assign risk badges to various schemes. And this is a good thing when compared to the old method of rating the risks of the schemes. Since many useful changes have been introduced, the Riskometer will now provide a comparatively better distinguishment of risks between various funds within and across mutual fund categories.

How exactly will risk-o-meter assess risk for mutual funds?

Various detailed parameters have been defined and a new scoring system has been introduced for this. So Let’s look at the guidelines in a bit more detail.

New ‘Risk-o-Meter’ for Debt Mutual Funds

The risk for various schemes in different debt fund categories will be assessed at 3 levels – namely Credit Risk, Interest Rate Risk & Liquidity Risk.

The risk value will be provided under the 3 heads as follows:

Credit Risk – Debt securities of schemes shall be valued for credit risk on a scale of 1-12 (with 1 being the least risk) as follows:

1. G-Sec/AAA/SDL/ TREPS: Rating 1
2. AA+: Rating 2
3. AA: Rating 3
4. AA-: Rating 4
5. A+: Rating 5
6. A: Rating 6
7. A-: Rating 7
8. BBB+: Rating 8
9. BBB: Rating 9
10. BBB-: Rating 10
11. Unrated: Rating 11
12. Below investment grade: Rating 12

Interest rate Risk – Debt securities of schemes shall be valued for interest rate risk on a scale of 1-6 (with 1 being the least risk) based on the Macaulay Duration of the scheme’s Portfolio. This will be done as follows:

1. Macaulay Duration of the portfolio < = 0.5 years: Rating 1
2. Macaulay Duration of the portfolio 0.5-1 year: Rating 2
3. Macaulay Duration of the portfolio 1-2 years: Rating 3
4. Macaulay Duration of the portfolio 2-3 years: Rating 4
5. Macaulay Duration of the portfolio 3-4 years: Rating 5
6. Macaulay Duration of the portfolio > 4 years: Rating 6

Liquidity Risk – As per SEBI, for measuring the liquidity risk of the schemes, their listing status, credit rating, and the structure of debt instruments will be considered. Very detailed guidelines have been provided (you can check them here). But to summarize, the debt securities of schemes shall be valued for liquidity risk on a scale of 1-14 (with 1 being the least risk).

And how will the 3 values coming out of the assessment of 3 types of risk (detailed above) be used together?

The Risk value for the debt portfolio shall be a simple average of credit risk value, interest rate risk value and liquidity risk value. There is one exception to this formula though. If the liquidity risk value is higher than the average of credit risk value, liquidity risk value and interest rate risk value then the value of liquidity risk shall be considered as the risk value of the debt portfolio.

I am no expert but I think that finally, the duration and credit aspect of the debt funds have been addressed and effort has been made to marry them under a tool. Usefulness is one thing but it’s a well-intentioned change no doubt.

New ‘Risk-o-Meter’ for Equity Mutual Funds

The risk for equity funds will also be assessed at 3 levels – Market Capitalization, Volatility & Impact Cost (Liquidity Measure).

The risk value will be provided under the 3 heads as follows:

Market Capitalization – Equity schemes shall be assessed for market capitalization as follows:

1. Large Cap: Rating 5
2. Mid Cap: Rating 7
3. Small Cap: Rating 9

As you already know, the market capitalisation data as published by AMFI every 6 months shall be used for this assessment. To know more about this market capitalization-wise categorization, read Large vs Mid vs Small cap stocks.

Volatility – Equity schemes shall be assessed on the basis of Daily Volatility of the Security price based on the past two years’ price of the security. This will be rated as follows:

1. Daily Volatility of Security price < = 1%: Rating 5
2. Daily Volatility of Security price > 1%: Rating 6

Impact Cost (Liquidity Measure) – Based
on the average impact cost of the security for the previous three months including the month under consideration following values shall be assigned:

1. Average Impact Cost of the Security for the month <=1%: Rating 5
2. Average Impact Cost of the Security for the month 1-2%: Rating 7
3. Average Impact Cost of the Security for the month >2%: Rating 9

The Risk value for the equity portfolio shall be a simple average of market cap rating, volatility rating and impact cost rating.

So that was about the ratings for equity and debt instruments.

The guideline goes more into detail for rating the other instruments like Equity Derivatives, Index Futures, and Stock Futures, Index Options and Stock Options, REITs & InvITs. The more commonly understood ones are also rated as follows:

• Investment in Gold and gold-related instruments by schemes shall be valued as 4 from a risk perspective. Read more about Using Gold ETFs & Gold Bonds for Long Term Portfolio.
• Investment by schemes in foreign securities shall be valued as 7 from a risk perspective.
• Cash and Net Current Assets shall be valued as 1 from a risk perspective.

If you are mathematically inclined, then you may want to see a few sample calculations of the Riskometer. SEBI has included them in the circular’s annexure itself. You can check it out there.

That’s it about the changes in the new Riskometer tool for mutual funds.

Before the Risk-o-meter’s current 6-level avatar, it was a 5-level Riskometer. And before that, it was a color-codes-based risk tool (it had 3 colors blue, yellow and brown representing low, medium and high levels of risk). After July 2015, SEBI replaced the depiction of mutual fund risks using color codes by a pictorial meter popularly named Riskometer.

SEBI has been constantly revising the guidelines once every few years for these Mutual Fund Riskometers. The idea has always been to highlight the risk to investors in an easy-to-understand format. Understanding the risks involved in any investment is very important for all investors. So this constant up-gradation of Risk-o-meter and how it works is a step in that direction.

But all said and done, is looking at Risk-o-meter sufficient to select the right mutual fund schemes for your investments?

No. Not at all.

Riskometer can only give an overall idea of the risk level of the scheme. But it’s not sufficient to just rely on it. Just like you are strongly advised to don’t rely on star ratings of mutual funds blindly. Similarly, you cannot rely blindly on risk-o-meter.

And to be honest, I have had my doubts about the usefulness of risk-o-meter (till now) and about how many people actually used to look at risk-o-meter and take investment decisions.

But nevertheless, it’s a step in the right direction and a good-intentioned initiative. At least now there is a mathematically-backed solid logical framework to the mutual fund Riskometer now. So it’s a good move in the long run. And help bring out some clarity (and transparency) on the risk labelling front.

I hope you now have a good understanding of the new mutual fund risk-o-meter, which has been revised in 2020 to enhance its product (risk) labelling effectiveness.