CNBCTV18 Exclusive: SEBI plans overhaul of mutual fund risk calculation, communication

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CNBCTV18 Exclusive: SEBI plans overhaul of mutual fund risk calculation, communication

Close on the heels of the rule changes for asset allocation in multicap funds, market regulator SEBI is planning an overhaul of the manner in which mutual fund risk is computed, assigned, and communicated, sources told CNBC-TV18.

The regulator is exploring ways to make the mutual fund Risk-O-Meter more representative of risk, sources said. Currently, the Risk-O-Meter displayed on mutual fund factsheets has five categories – Low, Moderately Low, Moderate, Moderately High, and High. SEBI proposes to introduce a new category-Very High.

Also, SEBI will mandate separate criteria for risk assessment of equity and debt funds, given the distinct features of the two asset classes.

The risk in equity funds will be judged on the basis of three parameters – market capitalisation, volatility, and impact cost. This is expected to give a better picture of the risk factors associated with the underlying stocks. This move is expected to impact mid and small cap equity schemes as well as those schemes holding these stocks. Sources said that all equity funds will be reclassified into ‘High’ and ‘Very High’ risk categories owing to the volatility in the stock market.

Debt funds, on the other hand, will be judged on the three parameters–credit quality of bonds, duration of bonds and their liquidity. After Franklin Templeton recently shut down three of its credit schemes abruptly, there have been calls for stricter criteria for managing the credit quality of bonds.

For example, SEBI currently defines all duration funds on the basis of the maturity of their underlying bonds. There is no threshold for the credit quality of these bonds. Similarly, all credit funds are defined only by the credit quality of their papers and not by their maturity profiles. Also, sources said there was no mandate currently to assess the liquidity available with each scheme. With the new parameters, these anomalies will be corrected. Since each parameter will carry a score, it will reflect all risk factors- credit quality, maturity profile, and liquidity.

Currently, the Risk-O-Meter is assigned on the basis of the category in which a specific scheme falls. But having a blanket risk profile for a category can give an incomplete picture. For example, all short term bond funds are currently classified as ‘moderately low’ risk but within the category, there may be schemes which are riskier than others.

Because the new risk classification will be score based, it will become scheme-specific and give a better picture to investors looking to put money in it.

Having a risk gauge assigned to individual schemes is a more comprehensive way of assessing the underlying securities in a scheme’s portfolio.

Just like all equity funds will be moved to the high and high risk category, in the debt space, credit risk funds which will be assigned a ‘Very High’ risk status.

Credit risk funds have seen consistent outflows for over a year and the overall assets under this category have shrunk to almost a quarter from last year. Re-aligning the risk level may therefore actually help revive this category by positioning it for investors chasing the high risk-high return combination.

Another big reform, according to sources will be that the Risk-O-Meter will have to be computed in real time and displayed in the scheme’s monthly fact sheet. As well, any change in the underlying assets will have to reflect in the scheme’s risk category.

This is pertinent for debt funds, which buy and sell bonds of varying credit profiles. It may happen that at some point, a scheme which falls in the moderately low risk category may be carrying a very high proportion of papers rated AA (double A) or less, contrary to its risk profile. In the new score based system, since each bond would be assigned individual scores, any fresh buying or selling of bonds would automatically reset the Risk-O-Meter. In essence, a scheme may carry different risk rankings through its life. Should any scheme require its Risk-O-Meter to be changed, the same has to be expressly communicated to the unitholders.

The final piece of these proposed mutual fund reforms is that asset management companies will now have to maintain an annual timeline of how the risk has evolved in each fund. This will help investors to better assess the risk style of the fund manager.

A few questions still need to be answered – How will the Risk-O-Meter be computed? Who will compute it in real time? and will SEBI have oversight?

All things considered, it may increase the compliance burden of mutual fund houses, but it will do go a long way in shoring up investor confidence in the industry and the regulator. It will also achieve a long-intended goal—that mutual funds spell out the risk clearly, concisely, and comprehensively.