Mutual fund (MF) investors may have recently received an e-mail asking for participation in a survey on the effectiveness of the risk-o-meter. Despite the initially-anticipated one-month duration, the survey, which featured comprehensive questions, concluded abruptly within a shorter period. Investors who ignored fund house mails would have missed the opportunity to participate. A somewhat similar survey, conducted by Axis Mutual Fund in September last year, unveiled a worrying statistic: about 61 per cent of respondents were unaware of the significance of the risk-o-meter. So, here’s a lowdown on the risk-o-meter, along with crucial factors that demand the attention of investors.

How it evolved

Educating investors about the levels of risk dates back to July 2013, with the objective of preventing mis-selling of MFs. Initially, the risk assessment process in mutual funds was more qualitative. Risk levels were colour-coded, with blue, yellow and brown signifying low, medium and high risks, respectively. However, this approach lacked the requisite depth for investors to comprehend the specific risk profiles of MF schemes leading to ambiguity and hindering investors’ ability to effectively compare different funds. For instance, all hybrid MF schemes were uniformly marked yellow, without distinguishing between categories such as conservative hybrid and aggressive hybrid.

Recognising these limitations in categorisation, in July 2015, SEBI prompted a more nuanced approach to the risk-o-meter. Asset management companies (AMCs) were instructed to adopt a graphical representation akin to a car speedometer, encompassing five risk levels: Low, Moderately Low, Moderate, Moderately High, and High. Each fund category was assigned a predefined risk level, offering a brief simplification for investors. Conversely, it did not consider changes in a fund’s portfolio or market conditions, leading to potentially outdated risk assessments. This again led the SEBI to introduce a “Very High” risk category in January 2021 with a detailed framework for the evaluation and disclosure of risk by AMCs every month.

Assessing equity and debt risks

The risk-o-meter, employing a six-point numerical scale, acts as a readily discernible risk-profiling tool for investors. The revised approach moved beyond solely assessing principal risk and incorporated a more granular analysis of specific metrics within a fund’s portfolio. For equity holdings, risk assessment considered three key factors with equal weight: market capitalisation of portfolio constituents, daily price volatility, and liquidity, as measured by impact cost. The final risk level was then derived from an average of these individual parameter scores. So, a fund with a final rating of 1 indicates minimal risk, commonly associated with fixed-income securities, while ratings of 5 or 6 signify higher-risk funds linked to equities or sectors susceptible to cyclicality. Conversely, in adherence to SEBI rules, foreign securities, including stocks, MFs, and ETFs, bear a high-risk score of 7.

On the fixed-income front, the debt funds are similarly evaluated on credit risk, interest rate risk, and liquidity risk. However, liquidity risk warrants additional attention after the fiasco of Franklin Templeton’s debt funds in April 2020. If a fund’s liquidity risk score exceeds the average of all three parameters, the overall risk rating will be solely determined by the liquidity risk score. This refined methodology provided investors with a clearer understanding of the specific risks associated with each scheme.

Supplementing the risk-o-meter, debt funds have also been disclosing the 3x3 Potential Risk Class (PRC) matrix since December 2021. This visual tool provides investors with the details of credit risk and interest rate risk. The PRC matrix utilises a simple layout: credit risk increases from left to right, while the interest rate risk increases from top to bottom. Each scheme is then assigned a specific box, based on the maximum potential risk it can incur within its portfolio composition. For instance, a fund in the A-I box would primarily invest in high-quality bonds with minimal interest rate sensitivity. Conversely, a C-III fund might invest in lower-quality bonds with substantial interest rate sensitivity. The PRC matrix allows for an independent analysis of credit and interest rate risks. This is particularly beneficial for situations like the Franklin Debt MFs’ fiasco, where only liquidity risk was present, which the risk-o-meter alone might not fully capture.

Takeaway

It is important to recognise that these tools serve as a starting point, and deeper scrutiny of individual portfolio holdings and fund strategies is recommended for comprehensive risk assessment. New investors must seek help from financial advisors and MF distributors to make the most suitable choices for their individual requirements.

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