InvestorQ : What is a risk-o-meter and why its good for the mutual fund investor?
Sadaf Khan made post

What is a risk-o-meter and why its good for the mutual fund investor?

ramya Bhaskaran answered.
2 years ago
Recently, 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. 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. The Risk-o-meter shall have the following levels of risk for MF schemes.

  • Low Risk
  • Low to Moderate Risk
  • Moderate Risk
  • Moderately High Risk
  • High Risk
  • Very High Risk

For equity mutual funds, broadly, there will be three factors - market capitalization, volatility, and impact cost. Stocks in the large-cap category will have a lower risk value of 5, while those in mid-cap will have 7, and small-cap will have 9. Similarly, lower volatility and impact cost will mean a lower risk value of, say, 5; higher read will mean a risk value of 9. The weighted average of these values will help arrive at the final risk-o-meter reading. Based on the formula prescribed by Sebi, most equity schemes are likely to fall either in the ‘high risk’ or ‘very high risk’ category. Under the earlier system, large-cap or equity ETFs fell in the ‘moderately high’ risk profile.
For debt schemes, New ‘Risk-o-Meter’ will involve the following-The risk for various schemes in different debt fund categories will be assessed at 3 levels – namely Credit Risk, Interest Rate Risk & Liquidity Risk.

Credit Risk – Debt securities of schemes shall be valued for credit risk on a scale of 1-12 (with 1 being least risk) as follows:
G-Sec/AAA/SDL/ TREPS: Rating 1
AA+: Rating 2
AA: Rating 3
AA-: Rating 4
A+: Rating 5
A: Rating 6
A-: Rating 7
BBB+: Rating 8
BBB: Rating 9
BBB-: Rating 10
Unrated: Rating 11
Below-investment-grade: Rating 12

Interest rate Risk – Debt securities of schemes shall be valued for interest rate risk on a scale of 1-6 (with 1 being least risk) based on the Macaulay Duration of the scheme’s Portfolio. 

Liquidity Risk – As per SEBI, for measuring the liquidity risk of the schemes, their listing status, credit 
rating, the structure of debt instruments will be considered. The debt securities of schemes shall be valued for liquidity risk on a scale of 1-14 (with 1 being the least risk).

The Risk value for the debt portfolio shall be a simple average of credit risk value, interest rate risk value, and liquidity risk value. There is one exception to this formula though. If the liquidity risk value is higher than the average of credit risk value, liquidity risk value, and interest rate risk value then the value of liquidity risk shall be considered as the risk value of the debt portfolio.

The Sebi circular says the risk-o-meter will have to be evaluated on a monthly basis.  Fund houses will have to label all their schemes within 10 days from the close of each month, along with portfolio disclosure. Also, any change in the risk-o-meter will have to be communicated to unitholders via SMS or e-mail. Further, MFs will have to disclose the risk level of schemes at the end of every financial year, along with the number of times the risk level has changed during the course of the year.

The risk-o-meter by SEBI is useful so that investors are aware of the risk they are getting into. Investment decisions are usually based on an investor’s risk appetite. Someone in their early or mid-twenties might have an aggressive approach towards investing in equities, whereas a retired person is likely to prefer risk-averse fixed-income investments. To help investors be aware of the risks associated with mutual fund investments, SEBI has made it mandatory for all fund houses to display a risk-o-meter depicting the six levels of risk effective January 1, 2021.