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.