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Published on: Jan. 27, 2021, 8:34 p.m.
A shaky risk-o-meter
  • Illustration: Panju Ganguli

By Business India Editorial

In a move that aims to help investors make a more informed investment decision, capital markets regulator Securities & Exchange Board of India (SEBI) has made it mandatory for mutual funds to assign a risk level to schemes, based on certain parameters. As per the new rules, the risk assessment for equity mutual funds will be calculated, based on three key factors: market capitalisation, volatility and impact cost or liquidity measure. The debt funds will be assessed for risk, based on calculating the simple average of credit risk, interest rate risk and liquidity risk. It replaces the old model based simply on a scheme’s category without adequately considering its actual portfolio. Mutual funds have to update the risk-o-meter on a monthly basis on their websites and the AMFI website, within 10 days from the end of the month.

From 2021 onwards, the new mutual fund risk-o-meter will have six levels of risks for mutual funds based on the credit score of the portfolio at the end of each month – low risk, low-to-moderate risk, moderate risk, moderate-to-high risk, high risk and very high risk. It aims to provide more transparency in the industry and help investors make a more informed decision by better capturing the inherent risks in mutual fund portfolios. 

A few key highlights to support our view are as follows: The risk-o-meter fails to provide a fair score for best rated short-term debt securities (A1+) by providing a risk score of five to the security, in case there is no long-term rating for the same issuer. The risk score of five, places the instrument in a high-risk bracket, without actively considering the strong liquidity position of the issuer that warranted the highest credit rating in the first place.

It gives equal weight to unlisted, bespoke structures, structured obligations, credit enhancements and embedded options while analysing the liquidity risk of an instrument, without considering other factors such as duration of options, nature of options, characteristics of structures, etc. This also presents a contradictory view by increasing the risk score in cases where the debt instrument has a call option for the investors which is aimed at reducing the liquidity risk. This approach treats the interest rate risk as the same in the case of sovereign securities, as it does for any other issuer of securities, by basing the interest rate risk only on Macaulay duration of the instrument.

In the case of equity-related instruments, the market risk assigned is based on the classification provided by AMFI, whereby the risk assigned to a company with Rs100 crore of market cap is the same as that of a company with Rs7,500 crore market cap. Although this approach may work for large and mid-cap funds, it fails to address the level of risk where small cap companies are a part of the portfolio.

  • From 2021 onwards, the new mutual fund risk-o-meter will have six levels of risks for mutual funds based on the credit score of the portfolio at the end of each month – low risk, low-to-moderate risk, moderate risk, moderate-to-high risk, high risk and very high risk

Furthermore, the risk-o-meter places all equity-based schemes in the category of either high or very high (on the basis of the lowest scores provided to any equity instrument). This makes it difficult for investors to assess and compare the level of risk for different equity-oriented schemes in the same category on the basis of product labels. Digging deeper into the approach, we find that it is expensive and laborious for mutual funds to source the data required for calculating the risk scores for their portfolio, as many data points used in the same are not available in the public domain.

The risk-o-meter also provides a standard approach to risk management for all types of portfolios irrespective of the investment strategy or risk management approach of different fund managers. Further, it fails to address the change in risk on the basis of a changing macro environment, which goes against the concept of dynamic risk management.

Although a step in the right direction, we believe that we are still far from reaching a standardised approach that can help us assess the risk of all types of portfolios in the industry. Each fund house and each fund manager have a different approach when it comes to managing a portfolio. A standardised approach like this may prove to be counterproductive in cases where fund managers rely on more detailed and complicated models of dynamic risk management.

Given these limitations, the new guidelines fail to achieve the primary objective of helping investors make informed decisions. In fact, they may create more confusion by complicating the risk assessment process without achieving the end result. Thus, we do not believe that investors can solely rely on the risk score of the new risk-o-meter. They still need to understand and evaluate various other risk parameters to compare and pick the right fund which suits their risk appetite.

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