scorecardresearch
Follow Us:
Sunday, January 17, 2021

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

Starting Jan 1, fund houses must disclose how risky a particular mutual fund scheme is, from 'low' to 'very high' risk. How will the risk be calculated, and how will it help investors make more informed decisions?

Written by Sandeep Singh | New Delhi | Updated: January 14, 2021 12:29:56 pm
mutual funds, mutual funds riskometer, mutual funds risk factors, mutual fund riskometer, mutual fund schemes, mutual funds risk o meter, investments, mutual funds and risksSEBI’s decision on the "risk-o-meter", which it announced on October 5, 2020, came into effect on January 1.

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

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

How will the risk-o-meter work?

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

The risk-o-meter must be evaluated on a monthly basis. Fund houses are required to disclose the risko-o-meter risk level along with the portfolio 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 reading with regard to a scheme shall be communicated to the unit-holders of that scheme, SEBI has said.

mutual funds, mutual funds riskometer, mutual funds risk factors, mutual fund riskometer, mutual fund schemes, mutual funds risk o meter, investments, mutual funds and risks Source: SEBI

How is this different from the older category risk level?

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

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

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

📣 JOIN NOW 📣: The Express Explained Telegram Channel

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

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

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

How will the level of risk be assigned?

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

How will the risk value be calculated?

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

While market cap value of a portfolio will be based on the weighted average of the market capitalisation values of each security (5 for large cap, 7 for mid cap and 9 for small cap), the volatility 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 greater than 1).

As for impact cost value, which is a measure of liquidity, the value would be the weighted average of impact cost values of each security (5 in case of average monthly impact cost 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 simple average of credit risk value, interest rate risk value, and liquidity risk value. However, 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 risk value of the debt portfolio.

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

For measuring the liquidity risk of schemes, listing status, credit rating, and structure of debt instruments is considered (1 for Gsec and AAA-rated PSUs, and 14 for below investment grade and unrated debt securities).

📣 The Indian Express is now on Telegram. Click here to join our channel (@indianexpress) and stay updated with the latest headlines

For all the latest Explained News, download Indian Express App.

0 Comment(s) *
* The moderation of comments is automated and not cleared manually by indianexpress.com.
Advertisement
Advertisement
Advertisement
Advertisement