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What is a risk-o-meter and how has it changed?

In a bid to help investors make informed decisions, the regulator has recently modified the risk-o-meter. Here we discuss the evolution of risk-o-meter and delve into new changes

What is a risk-o-meter and how has it changed?

If we ask you what returns your fund gave in the last one year, you'll probably give an instant answer. But what if we ask you about its risk profile? Maybe some of you might have some vague idea, but most won't bother to answer. For long, mutual fund investors have based their fund selection only on performance numbers, while ignoring the risk side of the equation, specifically on the fixed-income side.

The problem is that unlike returns, which investors can easily measure, they've never really had any risk-assessment tool to aid them. SEBI made some half-hearted attempts to fill that void in the past but they weren't of much use. As a result, the most common interpretation for investors has been that the funds giving higher returns were better investments, while those returning less were poor. But returns convey only one side of the story. Your impressions about a fund can change dramatically the moment you factor in the risks. In fixed income, the risk has always been latent but the happenings of the last two years have revealed the price one pays for the lack of its appreciation.
Don't believe us? Just trace back the rapid growth in the asset sizes of the six shuttered Franklin schemes alongside their standout performance year after year.
Now this problem is not unique to the six Franklin funds, even though they've become the poster boys for any discussion around risk. Across many debt-fund categories, there has always been a wide variation on the risk parameters. On the one hand, there are funds which have traditionally been more conservative. On the other, there are the more aggressive ones, which assume far-greater risk in pursuit of returns. But because of the absence of an objective, easy-to-digest risk measure, investors have never been able to distinguish between the two.
That now seems to be changing with SEBI's new and completely overhauled risk-o-meter that came into effect from January this year. Not only has the new, upgraded methodology fixed the issues with the older one, it captures all possible dimensions from which the risks emanate. In this article, we discuss about the origins of risk-o-meter and delve into what has changed.

Evolution of risk-o-meter
SEBI's first attempt to grade the risk in mutual funds started with the product-labelling system in 2013, which used colour codes - blue, yellow and brown - representing low, medium and high levels of risks, respectively (see the box 'The evolution of risk grading'). That moved a step ahead in 2015 with the introduction of the risk-o-meter, a pictorial depiction of risk on a scale of five, ranging from 'Low' to 'High'. In this avatar, SEBI fixed the risk labels for each fund category and each fund was simply assigned the same risk label as that of the category. But in reality, funds of the same category differed widely on risks based on their underlying portfolios. For instance, you could see huge variations in exposures to issuers with low credit ratings among different funds and yet the risk-o-meter would project them as being equally risky. So, it had little use for investors.

But the recent misadventures in the fund industry prompted SEBI to significantly upgrade the risk-o-meter. As per the revised methodology, risk grades are assigned based on the underlying portfolio holdings of a fund. It has also introduced a new risk label: 'Very High'. Therefore, a fund can now be assigned one of the following six risk grades: Low, Low to Moderate, Moderate, Moderately High, High and Very High Risk.

In the new risk-o-meter, the risk weights are assigned to the underlying securities based on specific parameters which are different for different asset classes.

For equity, each holding in the portfolio will be assigned a risk value on the following three factors:
Market capitalisation: A small-cap stock will have a higher risk value than a mid-cap stock, which in turn will have a higher value than a large-cap one.
Volatility: Stocks which witness a higher magnitude of ups and downs on a day-to-day basis will carry a higher risk ranking.
Impact cost (liquidity): Impact cost refers to the magnitude by which the price of a stock moves as a result of a large buy or sell transaction. For instance, stocks which have low trading volumes witness a significant jump in their price if a big buy order is executed, driving up the purchase price for a fund manager. This is referred to as the impact cost. The higher the impact cost, the higher the risk value.

For debt funds, the risk factors considered are:
Credit risk: This reflects the possibility of a borrower to not pay back. As you progressively move down the credit-rating curve from AAA to below-investment-grade securities, this possibility increases and so does the assigned risk value.
Interest-rate risk: The farther the maturity of the bonds in a portfolio, the higher the risk value on this parameter. That's because the prices of long-dated papers react more sharply to the ups and downs in interest rates. So, if interest rates increase by 0.25 per cent, the bonds whose maturity is farther away will fall more than the ones maturing in the near term.
Liquidity risk: This parameter refers to the inability to sell a bond before its maturity because of a lack of buyers in the market. The risk value is assigned on the basis of a bond's credit rating, whether it is listed or not and how it is structured (for example, whether or not it carries any credit enhancement). All these factors contribute to the liquidity of a bond.

Besides above, SEBI has provided detailed guidelines on assigning risk values to various other asset classes such as derivatives, gold, REITs, etc.

Once the risk values are assigned to the different parameters, the risk score at the fund level is a simple average of different parameters. For schemes that invest in more than one asset class, the risk scores of the respective asset classes are calculated and added up.

Why is it a big step forward?
This revised risk-o-meter has a lot going for it.

Rooted in reality: As mentioned earlier, it brings the risk grading closer to reality by basing it on what the fund actually holds.
Captures all dimensions of risk: We believe that the chosen parameters reflect all the relevant ones that contribute to the riskiness of various asset classes. One can argue that this methodology misses out on the concentration risk, i.e., the risk of investing too much in the securities of a single issuer. SEBI may want to consider it in a future upgrade but it doesn't take anything away from the comprehensiveness of the current framework.
The 'liquidity' master stroke: Among the three risk parameters for debt funds explained above, SEBI has given special power to the liquidity score. As you know, the risk value for a debt portfolio is a simple average of the credit-risk value, interest-rate risk value and liquidity-risk value. However, if the liquidity-risk value is higher than the average of all three, then the value of liquidity risk will be considered as the risk value of the debt portfolio.
We think this is of great significance because a lot of issues arise because of the inherent mismatch between the liquidity offered by debt funds versus the liquidity that markets in corporate bonds, particularly the lower-rated ones, have to offer. Even in the much-publicised episode of Franklin schemes, the fund house maintains that it's the lack of liquidity of the underlying portfolio, in the face of mounting redemption requests, which led to their winding-up. If we look at their risk grades as per the revised methodology (see the table 'Risk profile of Franklin's closed funds), all funds are marked on a higher risk scale. So, this new risk-o-meter could have served as an early warning signal for investors had it been in force back then.

Up-to-date: AMCs have to calculate the risk grades on a monthly basis, which ensures that they don't become dated and irrelevant in case the underlying realities change rapidly.
Prompt notifications: AMCs are mandated to inform investors by email and SMS whenever the risk grade changes. Not only that, every year, at the end of March, they also have to disclose the number of times the risk level has changed over the year. That should ensure that investors come to know of these changes and they don't get buried under volumes of other disclosures.

Therefore, the new methodology makes the risk-o-meter an objective, easy-to-understand and, most importantly, a relevant measure to evaluate and compare funds in terms of risk.