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The fund riskometer becomes active and relevant

Mutual fund investors now have a very useful tool which will track the risk level of each fund

The fund riskometer becomes active and relevant

Since 2015, there has been an official 'riskometer' for mutual funds. However, up until now, few mutual fund investors would have been familiar with the term, but this is set to change. Currently, each fund is rated on one of the five risk levels: Low, Low to Moderate, Moderate, Moderately High, and High. However, the riskometer has actually not been a fund riskometer but a fund category riskometer. The risk level of each official SEBI category was fixed by SEBI and each fund in that category was simply assigned that risk level automatically.

From January 1, this changes. The fund category riskometer system ends and a genuine fund riskometer system kicks off. The fund category riskometer had no connection with the actual portfolio of the mutual funds under it. Within the broad parameters of a fund category, there could be considerable variation of the actual risk level. Moreover, as the recent debt fund crisis has shown, risk can come from all sorts of directions, including lack of liquidity.

So among the spate of regulatory changes that have resulted from the ongoing debt fund crisis, a significant one has been added. SEBI has published an elaborate new riskometer guideline which lays down how the risk level of each fund will be calculated. In addition to the earlier five risk levels, a new one - very high - has been added. Most importantly, this risk level will be recalculated every month based on the fund's actual portfolio at the end of the previous month.

Not just that, the regulations also ensure that investors come to know of these changes - AMCs must inform them by email and SMS whenever the risk level changes. Not just that, investors must also be kept in the know about the frequency of these changes by being told how many times a year the risk level changed.

So how exactly will this risk level be calculated? I'm not going into the entire thing in detail because SEBI's published methodology itself runs into about 20 pages. We will publish a detailed analysis soon. However, suffice it to say that the algorithm takes into account everything that can possibly impact the actual delivered risk to investors.

Is this new arrangement a good thing for investors? In my view, it certainly is a good thing for investors to understand more about their investments and about the risk level of their funds' portfolios. This is something that most investors are blind to. The recent debt fund crisis would not have been much of a crisis had investors done so. A lot of investors did not appreciate that risk and returns were two sides of the same coin. They thought that some investment strategies could generate higher returns without understanding that such strategies came with higher risk too.

No doubt, this misunderstanding was encouraged by miscommunication from fund distributors who were selling on the basis of returns alone. The new arrangement will short-circuit such miscommunication by not only forcing a clear calculation of risk levels and the changes, but ensuring that funds bypass the sales channels and communicate this directly to investors. The calculation of the risk level itself would not be of full use without its dissemination to investors.

Could there be any downsides to these new requirements? I have no doubt that AMCs and fund managers will feel that this is an additional compliance burden that they could have done without. In fact I would expect that this is not just a compliance issue but will actually have an impact on fund management as well as product design. AMCs will become acutely aware of how the risk level will be impacted by the actions of fund managers. There is nothing wrong with this - in fact this is an expected outcome of these new regulations. Higher risk levels can no longer fly under the radar of investor and analyst scrutiny. There will be some rough edges in the nitty gritty of the methodology but that will get smoothed out as time goes by.

All things considered, this is a significant step in the evolution of more investor-friendly mutual funds.