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Brown is Riskier than Blue, or Is It?

SEBI's new standardised fund labels and colour codes will help investors make the right choice, but there are some nuances to the what the colours really mean...

Financial regulator SEBI has just introduced a standardised labelling system for mutual funds. The form and content pattern of this label has been rigorously prescribed by SEBI. The labels will be useful for investors to understand the basics of what kind of investment a fund is intended for and what it's risk profile is. In their interactions with fund salesmen, this should help investors sort out the hyperbole and the reality and ensure that they are being sold a fund whose intended purpose is clear.

To benefit from these labels, investors need to understand them and do their bit. It's somewhat like like the standardised 'Nutrition Facts' labels that are there on packaged food products. The label will only tell you the bare facts--for example, the quantity of sugar in a product. It's your job to figure out how much sugar you should consume in all and total it up for everything you eat.

The fund label will consist of three sentences of text and, in a first for any financial product, a colour code. In the three sentences, the label will state to a potential investor some basic facts about the fund. Here's an official example from SEBI.

This product is suitable for investors who are seeking:
* long-term capital growth
* Investment in equity and equity-related securities including equity derivatives of top 200 companies by market capitalisation
* high risk
The text is accompanied by a brown colour label. There is also an explanation of the colour labels. The brown label's explanation is 'investors understand that their principal will be at high risk'. The low and medium risks are indicated by blue and yellow labels respectively.

It is important to know exactly what this risk is and to understand that the colour code is not a value judgement. I was associated with the process of formulating these labelling rules and colours initially proposed for high and low risk were the traditional red and green used for the purpose. However, the many in the fund industry objected to this (rightly, I believe) that the psychological association of danger with red is is not appropriate in this case.

The risk levels in the labels are for short-term risk, although the label doesn't state that. In equity funds, real risk is highly time dependent. If you are investing for five to seven years or more, the risk of loss of principle is low and the risk-to-return trade-off is extremely favourable. This is well borne out in the historical performance of funds.

Conversely, if one looks at the real, inflation-adjusted returns then income funds (which will labeled low-risk in this system) actually carry a high degree of risk.

At the end of the day, there are two goals that this labelling system is likely to accomplish. One, it will reduce mis-selling by giving an investor a standardised piece of information that should prevent false claims by salesmen. Two, it will create three distinct categories of funds in the mind of investors and reinforce the idea that like must be compared only with like. They will see clearly that many of the funds that are officially labelled high risk have given high returns over the long-term. This should eventually lead investors to a better mental framework of choosing funds. The logic and utility of more nuanced categorisation systems like that of Value Research will also become clear.

Like all labelling systems, some companies will try and abuse this. Going back to the food example, the other day I came across a packaged 'organic' drink from a well-known brand which, according to the nutrition label, did not have any sugar. However, a close reading of the label revealed that this product had humongous quantities of fructose and glucose. Now, few buyers can be expected to realise that sugar is made up of these two. It's possible that a few in the fund industry will also try to pull some equivalent of this fructose-glucose trick. It's up to SEBI to ensure that that doesn't happen.