In continuation with its earlier measures, SEBI (Securities and Exchange Board of India) has come out with a detailed framework for evaluation and disclosure of risk associated with investing in mutual funds.

The securities market regulator has added one more level of risk ‘Very High’ to the existing five levels - Low, Moderately Low, Moderate, Moderately High and High – for depicting the associated risk with a mutual fund scheme.

Risk in the portfolio

More significantly, SEBI has introduced a detailed methodology for evaluating this risk. Under the existing system, risk in a mutual fund scheme is gauged (and displayed in the factsheet) in terms of the risk to the principal. This essentially boils down to the risk level depending on the scheme category. So, for instance, a short-term debt fund falls in the low-risk category, whereas a large-cap equity fund falls in a relatively higher risk category. A mid-cap equity fund would be riskier still.

Once the new methodology takes effect, the risk level of each mutual fund scheme will be evaluated based on its actual portfolio composition and not merely the category to which it belongs.

Multi-dimensional risk

Also, the risk will be evaluated after taking into account several factors and not simply the risk to principal. For example, debt securities in a scheme portfolio are to be evaluated based on credit risk, interest rate risk and liquidity risk. For equity holdings, the market cap, stock volatility and liquidity will have to be considered. The final risk level will be based on an average of the scores on each parameter.

Further, fund houses will have to do the risk evaluation monthly and communicate to investors any change in the risk level of a scheme.

While these are all steps in the right direction for investors, one needs to see how a more detailed and quantitative risk evaluation process gets finally reflected in the overall risk label (six levels) of a scheme. Further, investors may have to be prepared for possible monthly changes in the risk level of schemes they have invested in and a need to take a call on their investment.

The new changes will come into effect from 1 January 2021 for all existing and to be launched schemes.

Dividend scheme renaming

In another circular, SEBI has asked mutual funds to rename their existing dividend schemes from 1 April 2021 onwards. Dividend Payout will be renamed Payout of Income Distribution cum capital withdrawal option , Dividend Re-investment as Reinvestment of Income Distribution cum capital withdrawal option and Dividend Transfer Plan as Transfer of Income Distribution cum capital withdrawal plan . The intent is to disclose to investors clearly that dividends paid out to them come out of their own investment in the scheme.

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