How risky is your mutual fund scheme?
How do you answer the above question?
If you ask an investor, the answer will vary depending on, among other things, investor risk profile, investor mood, market sentiment and market outlook.
If you ask a mutual fund house, an underappreciation of risk in the investment is guaranteed.
As an investor, what should you do? What should be your reference point?
SEBI, vide a circular dated October 5, 2020, has tried to answer this question. SEBI has released a methodology to quantify the level of risk in an MF scheme. For easy visual understanding, a simple Risk-o-meter will have to be released for each scheme.
Please understand SEBI does not provide the risk ratings of MF schemes. SEBI has merely defined the methodology to calculate risk ratings. The AMCs have to release risk ratings for each scheme, adhering to the methodology.
The Risk-o-meter system comes into force on January 1, 2021.
Risk-o-meters for mutual funds have been around for many years. However, as I understand, the AMCs had a fair bit of discretion in choosing the risk rating of their funds. Now, SEBI has gone ahead and tried to quantify the risk-rating process and take such discretion away from mutual fund companies.
The Risk-o-meter shall have following levels of risk for MF schemes.
- Low Risk
- Low to Moderate Risk
- Moderate Risk
- Moderately High Risk
- High Risk
- Very High Risk
Here is the mapping between the risk value of schemes and the risk levels as per risk-o-meter.
We shall discuss later how risk values for different types of schemes are calculated. As expected, the risk value calculation method is different for equity and debt funds.
Risk-o-meter Calculation for Debt Mutual Fund Schemes
There are 3 types of risk SEBI has tried to quantify:
- Credit Risk (the underlying bonds may default)
- Interest Rate Risk (The bond prices fall with rise in interest rates and vice-versa. Duration is a measure of interest rate sensitivity of a bond or a mutual fund portfolio)
- Liquidity Risk (the risk that underlying bonds cannot be sold easily)
Each bond in the debt mutual fund portfolio will be rated on these parameters.
For more on risk in debt mutual fund schemes or how these risks affect you, refer to this post.
Below is the value assigned to each credit rating.
The credit rating of the mutual fund portfolio shall be the weighted average rating (weights shall be based on the AUM) of the portfolio.
Interest Rate Risk
Below is the interest rate risk value for Macaulay duration of the portfolio.
For measuring liquidity risk, the listing status, credit rating and structure of debt investments shall be considered. The Liquidity risk classification is a long table. I will reproduce a small part.
Liquidity risk value of the portfolio will be the weighted average (AUM based weights) of liquidity risk values of underlying portfolios.
Risk Value of the portfolio shall be simple average of Credit Risk value, Interest Rate risk value and Liquidity risk value for the portfolio. However, if the liquidity risk value of the portfolio is higher than the average rating (as calculated above), the liquidity risk value shall be considered as risk value of the portfolio. This is a good move as fund managers won’t be able to hide behind averages in case of illiquid portfolios.
Let’s understand this with the help of an illustration. I reproduce the illustration from the SEBI circular. The debt fund portfolio is made up of 10 securities. At the moment, all have equal allocation (10% each). The Macaulay duration of the portfolio is specified as 1.41.
Risk-o-meter Calculation for Equity Mutual Fund Schemes
In my opinion, this is not as useful. No matter what Risk-o-meter suggests, all equity fund schemes are carry high risk. Hence, I will cover this briefly.
The risk value of equity MF portfolios depends on the following 3 parameters.
- Market Capitalization (Large cap have lower risk score, Small caps have higher)
- Impact cost (Liquidity measure)
With this rating structure, almost all the equity funds will fall in the Very High Risk category, which is a fine classification. Equity funds are very risky.
The calculation of Equity MF risk-o-meter is exactly the same as for the debt funds. First, you find the weighted average risk score for each parameter and then take simple average of the 3 scores.
What about Hybrid, Cash positions, Gold, International Equity, Derivatives?
Equity funds come in multiple variants, where there is some exposure outside of stocks too. Hybrid funds can have exposure to debt securities too. In fact, most equity funds hold cash positions. Some funds also hedge their bets using derivatives.
An equity fund can invest in international stocks too. Then, there are multi-asset funds. There are gold funds.
- Gold gets risk rating of 4.
- International stocks get risk rating of 7.
- REITs and InvITs have risk rating of 7.
- Cash gets risk rating of 1.
In a multi-asset portfolio, the risk rating for each asset shall be determined separately. For instance, let’s say a multi-asset fund has 40% domestic equity, 30% debt securities, 15% gold and 15% international stocks.
Risk Value of the portfolio = 40% * Risk Value of Equity Portfolio + 30% * Risk Value of Debt Portfolio + 15% * Risk value of gold (4) + 15% * Risk Value of international stocks (7)
Detailed examples are given in the SEBI circular.
Points to Note
Any change is risk-rating shall be disclosed to the investors by way of an e-mail.
Risk-o-meter for each scheme shall be evaluated on a monthly basis and shall be disclosed along with portfolio disclosures every month. You can find portfolio disclosures on respective AMC websites. Risk-o-meter information shall be available on AMFI website too.
Additionally, the AMCs are required to furnish the following information in their Annual Reports and Abridged summary.
- Scheme name
- Risk-o-meter at the start of the financial year
- Risk-o-meter at the end of the financial year
- Number of changes in the Risk-o-meter during the financial year
Is the Mutual Fund Risk-o-meter helpful?
In case of equity funds, irrespective of the rating output the process throws up, the investors must understand that the equity funds are very risky. In any case, equity fund risk value is likely to be Very High. Hence, risk-o-meter offers little value for equity MF investors.
However, in my opinion, these ratings are extremely useful for debt mutual funds.
Earlier, you had to look at the debt fund scheme category, the credit quality of underlying portfolios, and portfolio duration before you made your choice. How to select the right debt fund for your portfolio? While you must still look at these aspects (we know credit ratings from rating agencies are not reliable), the Risk-o-meter score will serve as the first filter.
Moreover, if your debt mutual fund scheme has a high-risk value score, you need to dig deeper, especially if you thought of debt mutual funds as a replacement for bank fixed deposit. Understand and appreciate the source of risk. And decide if you must continue to hold the fund in your portfolio.
If you bought a low risk debt fund and its risk-o-meter value has gone up (risk has gone up), find out the reasons.
As discussed, AMCs are also required to notify the change in risk-o-meter values by e-mail. Keep an eye on such communication.
In debt funds, excess returns usually come with higher risk. For instance, a debt fund A can invest in low quality credit paper and generate extra returns (in good times). If you look at just the returns, you will rate this fund ahead of debt fund B that invests solely in AAA rated paper. While you could have noted this difference even earlier simply by looking at the portfolio, a risk-o-meter value provides an easy reference point. If Fund A with higher returns has high risk-o-meter value, you know there is no free lunch.
In debt funds, I will likely go with Low-risk or Low to Moderate risk funds.
A good move by SEBI.