New risk-o-meter bodes well for investors

By Ravi Samalad |  15-10-20 | 
 
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About the Author
Ravi Samalad is Assistant Manager - Editoral for Morningstar.in.

Following the recent episodes in the debt market, Securities and Exchange Board of India, or SEBI, has overhauled the product labelling guidelines in a bid to help investors better understand the risks associated with each fund.

What has changed?

Earlier, the risk-o-meter was not dynamic. It didn’t reflect the underlying change in the portfolio composition, unless a fund was merged with another fund or the fundamental attribute of the scheme itself changed. Now, the risk-o-meter is more dynamic and reflects the current state of the portfolio.

Henceforth, fund houses will be required to communicate to investors if the risk level in a scheme undergoes a change. The risk assigned to each fund will have to be evaluated on a monthly basis and modified as per the changes in the underlying portfolio.

What has changed in the new risk-o-meter for investors? So far, fund houses were showing 5 levels of risks: low, moderately low, moderate, moderately high and high. Now, the risk-o-meter will display one more notch of risk - very high risk.

Methodology

Fund houses now have to follow a templated methodology for calculating the risk value for each fund.

For debt funds, schemes will consider parameters like liquidity risk, interest rate risk and credit risk. For instance, while evaluating credit risk parameter, gilt securities will be assigned a value of 1, AA+ rated paper will be assigned a value of 2, and below investment grade paper on the other extreme will be assigned a value of 12. Higher value (12) denotes higher risk while a value of 1 denotes low risk.

AMCs have to assign a final value derived from the weighted average value (weight based on AUM) of each instrument. The final rating assigned to the scheme is calculated by taking the simple average of all the underlying parameters (liquidity risk value, interest rate risk, credit risk, etc.).

Debt funds will now give higher importance to liquidity risk. If the simple average risk value of a debt scheme gets a score of 3.8 (average of liquidity risk, credit risk and interest rate risk) while the standalone liquidity risk profile value is 4, the fund will have to denote the risk rating as 4. A value of 4 means that the scheme is bucketed under moderately high risk category.

Value - Risk

  1. Low
  2. Low to Moderate
  3. Moderate
  4. Moderately High
  5. High
  6. Very High

Equity funds will factor in parameters like market capitalisation, volatility of the stock price, impact cost, cash, and so on. While assessing the market capitalisation risk value, large cap stocks will be assigned a value of (5), mid caps (7) and small caps (9).

Mutual funds are required to comply with this diktat from January 1, 2021.

Dwijendra Srivastava, Chief Investment Officer, Debt, Sundaram Mutual Fund, says the revised norms will help investors. “Fund houses give out many such disclosures in the public domain and discerning investors look at them to make informed decisions. The methodology to measure risk on the fixed income side is exhaustive and very explicit. More disclosure is good for the industry and investors. It is distributors/adviser’s responsibility to explain the product risk profile well to investors.”

Level playing field

Fund officials say that the new product labelling guidelines have plugged an important loophole. So far, risk was being assigned based on category. For instance, a large cap and a small cap fund would both be categorised as moderately high risk funds, even if small caps stocks exhibit higher drawdown in comparison to large caps. Now, the new risk-o-meter will reflect the true picture of the fund and should raise a red flag, should the quality of the portfolio undergo a change, especially in debt funds.

“If low risk funds such as ultra short term funds hold high risk paper, the risk-o- meter will now flag it. If there is a blip, and resultantly the risk profile changes, fund houses have to communicate it to investors. Advisers and investors can now clearly see how the risk profile of a scheme has changed over one year or how many times it has changed in one year. It is a good first step by SEBI. The methodology in equity valuation is not as exhaustive as it is in the fixed income funds. Going ahead, we may see some fine-tuning by SEBI on the equity side,” says Swarup Mohanty, Chief Executive Officer, Mirae Asset Mutual Fund.

Does low risk mean your capital is protected?

In the current regime, liquid funds are labelled as low risk products. While the product labelling does provide a hint of the risk a fund carries, investors should err on the side of caution and consult their financial adviser before choosing a fund. Low risk does not mean that your capital is risk-free, especially in mutual funds. It is worth noting that even liquid funds have delivered negative returns on a few occasions. Data from Morningstar Direct shows that during the week of March 15, 2020, to March 21, 2020, many liquid funds yielded negative returns as yields jumped due to the panic redemptions in response to COVID-19 outbreak. However, such instances are few and far between. Investors make up for the lost returns if they stay invested in the fund.

Take another example. Franklin India Credit Risk Fund and Franklin India Ultra Short Bond Fund, which were among the six schemes that shut down in April 2020, are denoted as suitable for investors who wish to take moderate risk as per the current risk-o-meter. If someone, would have invested in the fund by merely looking at the risk-o-meter, their money would have been locked up. Thus, risk-o-meter could be just a starting point in matching the risk profile of a scheme with your own risk appetite. Investors should look under the hood to evaluate the quality of the paper. The chances of AAA rated paper being downgraded are not ruled out. The new risk-o-meter addresses this concern.

Kaustubh Belapurkar, Director – Manager Research, Morningstar Investment Advisers India, shares his perspective on risk-o-meter and how investors should use it.

The granular portfolio approach in the risk-o-meter is a step in the right direction, allowing investors to compare relative risk levels of funds within the same category based on underlying fund portfolios. It will also be beneficial for existing investors to gauge if there have been changes in the underlying risk of the funds they are invested in. Investors should look at this as another useful comparison metric when picking funds for their portfolios but shouldn’t be the only decision-making tool. Investors will need to keep in mind the appropriateness of the fund from an asset class exposure, fund category & investment time horizon. Additionally, investors should further understand the underlying sources of risk for each fund type and invest appropriately. There are other areas for improvement too when it comes to the methodology, for instance, it would be more appropriate for risks such as credit risk and liquidity risk to have an exponential scoring curve rather than a linear one to better represent the risk associated with lower rated credits.

Evolution of product labelling

Product labelling guidelines were introduced in 2013 in a bid to provide investors with a reasonable understanding of the kind of fund they are investing in and its suitability. From 2013, funds started disclosing the nature of the scheme (short, medium or long term), investment objective (equity, fixed income, gold, etc.), followed by three labels – blue (low risk), yellow (medium risk) and brown (high risk).

In 2015, SEBI increased the level of risks from three to five notches and introduced risk-o-meter.

To sum up, investors should not get overwhelmed by the exhaustive valuation methodology. That is for the fund houses to take care. What investors will get to see is the outcome – which risk profile the scheme fits into.

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