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SEBI rejigs the risk-o-meter

In a bid to help investors make informed decisions, the regulator has modified the product labelling guidelines in mutual funds

SEBI rejigs the risk-o-meter

Upgrading the methodology to arrive at the risk-o-meter of a fund, SEBI has published a detailed circular with revised guidelines on how to calculate the risk of every mutual fund scheme. Here we explain what it is and what to expect out of it.

Risk-o-meter is a pictorial depiction of the risks inherent in a mutual fund. SEBI has introduced a brand-new risk label - 'very high' risk. Six levels of risk will now range from Low, Low to Moderate, Moderate, Moderately High, High and Very High Risk. This assessment will be based on the underlying portfolio holdings.

As mandated by the regulator, risk weights will be assigned to the underlying securities on the basis of specific risk elements. For debt funds, the risk factors under consideration include credit risk, interest rate risk and liquidity risk. For equity funds, three risk parameters covered are market capitalisation, volatility and impact cost, which is a measure of liquidity. For both debt and equity funds, risk values will be calculated as a simple average of different parameters. For schemes that invest in more than one asset class, the risk score of respective asset classes will be calculated and then, added up.

Every fund house will have to evaluate the risk-o-meter on a monthly basis. AMCs will have to disclose the risk-o-meter, along with portfolio disclosure, for all their schemes on their websites, as well as on AMFI's website within 10 days from the end of each month. Further, AMCs will be required to disclose the risk level of schemes as on March 31 of every year, along with the history of risk-o-meter changes over the year, on the websites of AMCs and AMFI.

As per the circular, the new labelling and methodology will come into effect from January 1, 2021, however, AMCs can choose to adopt the provisions before the effective date.

This move is a step in the right direction. Broadly, it appears that SEBI has covered all the relevant characteristics from which the risk emanates. For instance, in debt funds, all the three risk considerations - credit, interest rate and liquidity - have been accounted for.

The calculations may get slightly complicated but for an investor, the interpretation is straightforward. With the kind of disclosures to be available, investors will be able to compare funds and figure out which appears riskier vis-à-vis its peers.

So, for an investor, risk-o-meter aggregates to a simple measure to assess the underlying fund-level risks and compare with peers. While returns are there to evaluate funds, investors didn't have any objective measure to look at risks. But this rejigged risk-o-meter will hopefully fill the gap.

Although we have yet to see the impact of these changes, putting things in such an objective framework may deter AMCs from assuming a higher degree of risk, especially in the funds that are ideally not supposed to assume that kind of risk. Even if AMCs do, then those will be identifiable among their peers.