Sebi’s new risk-o-meter for mutual funds is a useful tool but investors need to understand it first

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The new version of the official ‘risk-o-meter’ for mutual funds has started operating. The new risk levels have been announced and many investors are finding that the announced risk level of their funds has increased from the old system to the new and are somewhat worried about it. There are others whose risk level has gone the other way and are presumably happy. Either way, investors should understand what the risk meter is and what it isn’t.

The original risk meter had each fund being rated one of the five risk levels: Low, Low to Moderate, Moderate, Moderately High, and High. However, that meter was actually not a fund risk meter but a fund category risk meter. The risk level of each official Sebi category was fixed by the regulator and each fund in that category was simply assigned that risk level automatically. This was based on what the broad parameters for the category’s investments were.

Clearly, this fund category risk meter had no direct connection with the actual portfolio of the mutual funds under it. Within the broad parameters of a fund category, there could be considerable variation of the actual risk level, and there was. Moreover, as the recent debt fund crisis has shown, risk can come from all sorts of directions, including lack of liquidity. On top of that, the old risk meter was completely static. Since the category guidelines never changed, the stated risk level never did either. In essence, that system was a way of choosing which category best suited an investor and had no useful inputs to offer on the choice within each category.

Now, all that has changed. The biggest change is that this risk meter is based on the actual portfolio of each fund. This means two things. One, the reading on the risk meter helps you judge whether to invest in that fund. And two, even more importantly, as the portfolio changes and market conditions change, the risk level may change and that helps you decide whether to redeem a fund. This dynamic nature of the risk level can be a real help but it also means that investors have to keep track of the changes. The regulations help by enforcing fund companies to proactively inform investors in each fund about any changes in the risk level.

This change makes some investors uncomfortable. A few days back, in an online Q&A about Value Research’s star ratings to a particular fund, an investor complained to me that he had invested in a fund because it had been rated five stars but that rating has now been lowered. I explained that this was precisely what the ratings were for and if we never changed the ratings then they would be worthless. Trying to invest in a good mutual fund is a moving target and it places upon an investor the responsibility of keeping track of changing conditions.

There’s a further caveat that is there in the risk meter system, which pertains to the meaning of the word risk itself. What exactly does risk mean? In debt funds, the answer is simple. Debt funds are expected to move in a narrow range, without any unexpected credit or liquidity compromises. Sebi’s underlying algorithm for the risk meter takes into account these factors. Perhaps there will be some tweaks in the future but the principles align with what investors in debt funds think risk is.

Equity funds are a different matter altogether. Here’s an example: the risk meter algorithm takes volatility as a major input to risk and accordingly raises the risk rating of a portfolio if it has more mid-cap and small-cap stocks. However, as an investor, this may not align with your idea of risk. If you are doing an SIP for 5-7 years in a set of well-chosen mid and small-cap funds then the en-route volatility is irrelevant (or even helpful) to you. Over your chosen time period, your chosen ‘highrisk’ fund may deliver higher returns. If your own definition of risk is the likelihood of not being able to get the returns you want, then that’s a very different thing compared to what Sebi’s algorithm will tell you. As in every other aspect, equity investing is more complex and requires a deeper understanding.

In any case, a knowledgeable and well-informed investor would want to have a good understanding of what any rating or risk system actually does.

(The writer is CEO, Value Research)