Q. I'm a 50-year-old self-employed businessman, my wife is a housewife, and my children are settled abroad. I have been investing in fixed-income schemes offered by public sector insurance companies such as LIC. I have been thinking about investing in mutual funds for a long time, however, I do not understand the risk grading mentioned in the scheme information document of mutual funds. Can you please elaborate on how different mutual fund schemes are given risk grading?
Dhola Ram Yadav, Pilibhit, Uttar Pradesh
The concept of riskometer - indicating the risk associated with mutual funds was first introduced by the Securities and Exchange Board of India (SEBI) in 2015. The initial mechanism assigned risk to each mutual fund based on the category of the mutual fund, effectively all the mutual funds in a particular category of the mutual fund had the same rating.
This initial risk rating mechanism was not very popular amongst the industry or the investors as it in effect assumed that all the mutual funds of a particular category of mutual funds have the same level of risk associated with them. It ignored the different investment strategies, asset quality, performance, etc., of mutual funds situated in the same category.
In 2020 SEBI came up with fresh guidelines to calculate the risk associated with mutual funds. Deviating from the older mechanism, now the risk associated with each mutual fund is not dependent on the category of mutual fund it is situated in. In the current risk grading system, the risk grading of a particular fund depends on the kind of assets in which the mutual fund is investing.
For example, in the case of an equity mutual fund, the risk grading of the mutual fund depends on market capitalisation, volatility and impact cost (liquidity).
Below are the key highlights of the new risk grading framework applicable to mutual funds:
1. Riskometer: Riskometer under the new grading framework has the following six levels of risks:
- Low Risk
- Low to Moderate Risk
- Moderate Risk
- Moderately High Risk
- High Risk
- Very High Risk
2. Mutual funds are legally obligated to assign the risk level at the time of the launch of the mutual fund scheme/New Fund Offer (NFO).
3. The riskometer grading of the mutual fund is evaluated on a monthly basis by the mutual fund.
4. Any change in the riskometer grading of a mutual fund needs to be communicated to the unitholders by the mutual fund house through email or SMS.
5. The riskometer grading of mutual funds needs to be compulsorily displayed on the website of the mutual fund house.
6. On the front page of the initial offering application form, the scheme information document and key information document risk grading of the mutual fund scheme should be disclosed.
7. Risk analysis of underlying debt instruments/assets in which a mutual fund has invested in, is undertaken basis analysis of the following parameters:
- Credit risk.
- Interest rate risk.
- Liquidity risk.
8. Risk analysis of underlying equity instruments/assets in which a mutual fund has invested in, is undertaken basis analysis of the following parameters:
- Market capitalization.
- Volatility.
- Impact Cost (liquidity measures).
How useful is riskometer grading?
Riskometer grading is very useful if an investor is trying to understand the risk associated with the different categories of debt mutual funds. There are more than 16 categories of debt mutual funds, and very often investors get confused in relation to the risk associated with different debt mutual fund schemes.
However, when it comes to equity mutual fund schemes the situation is not that clear, under the new risk grading framework nearly all equity mutual fund schemes have been classified as high-risk category, it is unjust to equate the risk associated with equity mutual fund tracking Nifty 50 (in effect India’s best 50 companies) and a smallcap mutual fund tracking companies which are not even in the top 250 companies of India in terms of market capitalization. This will in effect discourage new investors from investing in equity mutual funds.
Does high-risk guarantee high returns?
In the case of mutual funds, returns are not guaranteed. Unlike fixed income schemes there is no certainty or legally binding contractual guarantee in respect of your investments. There is even a possibility that you may lose even your original investment. The risk grading of a mutual fund does not guarantee any kind of returns, however, typically an equity mutual fund has the potential to provide better returns than a debt mutual fund.
How to use riskometer when investing in mutual funds?
Riskometer can be a useful tool to gauge risk relatively when investing in debt mutual funds. When you evaluate debt mutual funds you will find that in the case of every category of debt mutual funds most of the mutual funds have a similar investment strategy and consequently, most of them have similar risk grading.
For instance, the dynamic bond funds cluster up in the "Moderate" category. You can use it for two purposes (a) you can evaluate whether “Moderate” risk grade suits your risk appetite, and (b) you can evaluate your current or potential investment in the same category using “Moderate” as the benchmark. If your fund is situated in the same category but has been risk rated as “High Risk” you should probably do a deep dive into the investment being made by your mutual fund and thereafter, you should evaluate whether the fund in question is aligned to your investment goals.
Conclusion
The risk grading mechanism in India is currently evolving. It is not a perfect indicator of the risks associated with mutual funds. However, it can help you in comparing the risk associated with debt mutual funds. If you are thinking of investing in debt mutual funds you should ideally check the risk grading of your selection and its peers situated in the same category.
Kuvera is a free direct mutual fund investing platform.
Note: This story is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.
