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Business News/ Money / Personal Finance/  Risk-o-meter is a good starting point but don’t rely on it alone
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Risk-o-meter is a good starting point but don’t rely on it alone

The risk-o-meter considers three parameters each for fixed income and equity securities
  • The level of risk the fund has taken in the past and how often the risks have changed give clues to a fund’s approach and consistency
  • How well investors can use the risk-o-meter will depend upon how well they understand the systemPremium
    How well investors can use the risk-o-meter will depend upon how well they understand the system

    Investors saw one more iteration to the representation of risk in mutual fund schemes when the Securities and Exchange Board of India (Sebi) came out with the modifications to product labelling requirements. The new methodology sharpens the focus on the portfolio of each scheme so that the risk-o-meter reflects the underlying portfolio and makes it a dynamic tool available to investors to track risks in the schemes.

    The risk-o-meter considers three parameters each for fixed income and equity securities. In case of a fixed-income portfolio, each security will be assigned a risk score for credit risk, interest rate risk based on the Macaulay Duration of the portfolio and liquidity risk. For equity portfolios, the categories for which each security is scored are market capitalization, volatility risk and liquidity risk. The weighted average of each risk will be calculated with the weight being the assets under management (AUM) of the security. The final score will be the simple average of the three risks. The score so arrived at will be mapped to a risk level on the risk-o-meter that will range from low risk to very high risk.

    How well investors can use the risk-o-meter will depend upon how well they understand the system. We lay it out for you here.

    What this means

    “The risk-o-meter now reflects the portfolio of a scheme better, and, therefore, there is greater relevance to the investor. The standardization and better labelling of the risks along with the periodic revision and communication of any change to investors are all features that make it a good tool to keep track of the risk in their investment," said Ganesh Ram, business head, mutual funds, BSE.

    The big step forward that has been taken is that it moves from describing the risk in category and the investment objective to throwing light on the portfolio of the scheme so that investors know better what they are getting into.

    Sebi has standardized how the risk score would be calculated taking away the possibility of arbitrary assessment of risk by the mutual fund. The guidelines now make the risk-o-meter a more effective tool for investors to gauge the risk and to compare across schemes.

    For example, debt schemes in categories like ultra-short, low duration and others that would take higher credit risk for better returns will now find that the strategy translates into a higher risk rating.

    In the equity fund categories, the scoring for risk is such that only the schemes investing in large-cap stocks with the lowest volatility and impact cost will get a risk rating of “high risk". All other equity schemes, irrespective of the category, investment strategy and scheme portfolios, will be classified as “very high-risk". This has the advantage of acting as a red flag for investors if they were being sold an equity product that does not suit them.

    “The new risk-o-meter gives the right representation of risk, especially for comparison between schemes in a category. It can be used better if the risk scores of a scheme are also available for evaluation apart from the rating chart," said Gajendra Kothari, managing director, Etica Wealth Management Pvt. Ltd.

    Investors evaluating a scheme will now have historical risk footprints, along with historical return to consider before deciding. The level of risk the fund has taken in the past and how often the risks have changed give clues to a fund’s approach and consistency in managing the portfolio, all of which are important markers to consider while evaluating a scheme.

    “A frequent change in risk can work as a warning, and if investors are not comfortable with the strategy, then it serves as a trigger to switch schemes. This may mean exit loads and taxes, but it’s better than being caught unawares," said Ram.

    Mind these slips

    For equity funds, the risk-o-meter works more as a cautionary tool. This is because, except for a large-cap portfolio that stays close to the index, all other schemes will be rated “very high risk". The risk-o-meter will also be ineffective in communicating an increase in risk in such equity portfolios since they are already in the highest risk category. So, if a multi-cap fund that has a predominantly large-cap portfolio now moves to take greater exposure to the higher-risk mid- and small-cap segments, the risk score will go up but the risk-o-meter will not communicate this change to the investor since the equity fund is already in the very high-risk category.

    One way an equity fund can have a lower risk rating is by holding a larger portion of the portfolio in cash. This strategy, however, comes with its own set of risks. One of the risks is associated with market timing, which investors may expose themselves if they were to chase a lower risk rated equity fund.

    The “very high risk" tag to all equity funds may scare off investors, whose portfolios may benefit from investing in equity, given their investment horizon. “The lay investors do not understand the nuances of risk well. They may avoid an equity scheme just because it falls in the ‘very-high risk’ category even though they have the required investment horizon. Very often investors need encouragement and convincing to select the right product," said Kothari. The nuances of investing, say the diversification advantages of international securities, in reducing the risk in a portfolio is best explained by an adviser.

    Using the risk-o-meter alone as a criterion for selection in the debt fund category too may lead to investors taking on more risk than they budgeted. This is because the risk-o-meter considers the duration of the portfolio to score the portfolio for interest rate risk instead of the duration of individual securities like it does for other risk parameters. This makes it possible for funds to hold long-term securities in a short-term portfolio with the attendant risk of greater volatility as long as the average portfolio duration is within the appropriate bandwidth.

    Apart from the volatility that such holdings bring to the portfolio, the closure of six debt schemes of Franklin Templeton in April showed the risk of liquidity when a short-term portfolio holds long-term securities.

    “Do not use the risk-o-meter as the only factor you will consider to evaluate the risk in a scheme. It is a complimentary metric," said Ram. For an investor with a long investment horizon, the volatility in a gilt fund may be acceptable but the risk of default in a credit fund may not be. The risk-o-meter will not help you make that choice unless the scores for different parameters are also available.

    Similarly, a high-risk product like a diversified equity fund may be acceptable to a long-term investor willing to take the interim volatility but may still not be comfortable with the risk of concentration in a sector fund though both may have the same risk rating. Therefore, it is important to see what the portfolio holds to make the right selection. The risk-o-meter is one more step in the right direction for investor protection but it does not absolve them from conducting due diligence before making a decision.

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    Published: 19 Oct 2020, 09:22 PM IST
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