Understanding Mutual Fund Riskometer
Investment decisions are usually based on an investor’s risk appetite. To help investors be aware of the risks associated with Mutual fund investments, SEBI has made it mandatory for all fund houses to display a riskometer depicting levels of risk.
The market regulator recently brought few new measures for the mutual fund industry so as to make the picture of riskometer more investor-friendly and to bring transparency in the risk associated with mutual fund schemes.
What is a Riskometer?
In March 2013, SEBI introduced the concept of ‘product labelling’ for the MF industry. The move was aimed at helping investors interpret the inherent risk associated with a scheme through easy-to-understand colour code boxes. In the initial phase, the product labelling system used three colours — blue - to denote low-risk, yellow – to represent medium risk and brown – to denote high risk. Accordingly, all fund houses shall display the product label including color code boxes depicting the levels of risk, in all scheme related documents and advertisements.
Effective July 01, 2015, SEBI replaced the depiction of risk through color codes boxes with pictorial meter named ‘Riskometer’ and this meter would depict the level of risk in any specific scheme out of the 5 levels specified by SEBI. .
Five years later, the regulator further improved the system and in October 2020 SEBI mandated that effective January 01, 2021, the riskometer with six levels, instead of five. Accordingly, from January 01, 2021, the riskometer consisting of five risk levels, was replaced by six groups of risk. The labels of risk level now range from ‘low’ to ‘very high risk’. SEBI also laid down detailed guidelines for evaluation of risk levels of the schemes.
Effective January 01, 2021, level of risk depicted by a pictorial meter (known as a riskometer) as under:
- Low - Principal at low risk
- Low to Moderate - Principal at moderately low risk
- Moderate - Principal at moderate risk
- Moderately High - Principal at moderately high risk
- High - Principal at high risk
- Very High – Principle at a very high risk
What will be the key factors to determine riskiness of equity and debt schemes?
On monthly basis, the risk level for the schemes shall be evaluated, based on the securities in which the scheme invests, namely, equity, debt, derivatives, foreign Securities etc. and based on the AUM of these security forming part of the scheme portfolio as on last day of the given month. As per SEBI guidelines, the underlying securities of a scheme shall be assigned a value for the parameters like volatility, credit risk etc. based on which the risk level will be calculated.
The Equity securities are assessed based on the following 3 parameters.
- Market Capitalization
- Volatility
- Impact Cost (Liquidity Measure)
In Debt securities, the risk is categorized based on the following 3 parameters
- Credit Risk - Based on the rating of each Security
- Interest Rate Risk - Based on the Macaulay Duration of the portfolio
Liquidity Risk - Based on listing status, Credit Rating and Structure of Debt instrument
How are the risk categorized?
Previously, the riskometer had five levels of risk – Low, Moderately Low, Moderate, Moderately High and High.
However, now the riskometer will be acquainted by the sixth level of risk, i.e., "very high risk."
Risk Level Suitable For Investor Profile
- Low Conservative Investor is willing to accept minimal risks and hence, might receive minimum or no returns.
- Low to Moderate Moderately Conservative Investor is willing to accept small level of risk in exchange for some potential returns over the medium to long term.
- Moderate Moderate Investor can tolerate moderate level of risk in exchange for relatively higher potential returns over the medium to long term.
- Moderately High Moderately Aggressive Investor is keen to accept higher level of risk in order to maximize potential returns over the medium to long term
- High Aggressive Investor is willing to accept significant risks to maximize potential returns over the long term and is aware that he/she may lose all or significant part of capital.
- Very High Very Aggressive Investor is willing to accept very high risks to maximize potential returns over the long term and is aware that he/she may lose all/ significant part of capital.
How often will a fund house have to review the labels?
SEBI mandated that the riskometer will have to be evaluated on a monthly basis. Fund houses will have to define the risk level of their schemes within 10 days from the close of each month, and will have to display it along with portfolio disclosure. Also, any change in the riskometer will have to be communicated to unitholders via publication of notice in the newspapers, SMS or E-mail. Further, disclosures regarding risk level of schemes at the beginning and end of every financial year along with the number of times the risk level has changed during the course of the year shall be made on their website, AMFI website and Annual Reports.
Further investors are always advised to read the scheme related documents to understand the investment objective and various risk factors associated with the Scheme and should consult financial/tax advisors to understand the suitability of the Scheme.
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Mutual fund investments are subject to market risks, read all scheme related documents carefully.