Mutual Fund Riskometer Explained in 2022: Riskometer Levels, Calculation
Everyone has heard the phrase “mutual fund investments are subject to market risks” at least once in their lifetime. And, the reason this line is repeated countless times is that the investment in mutual funds carries various degrees of risks.
It is important to understand the degree of the risk involved before investing in the fund. A Riskometer helps you with that. A Riskometer’s job is to give you a brief sense of risk or volatility you’ll be subjected to when you consider investing in a mutual fund. A Riskometer gives you an idea of the risk you will be taking beforehand.
In this article, we will see how risk-measurement works, the old techniques of risk measurement, and the latest advancements in Riskometers.
Old method to measure risk
Let’s start from the basics. The Riskometer was introduced by the SEBI (Securities and Exchange Board of India) in 2015 to simplify the risk levels as explained above.
There were five levels of risks as per this model. The titles of these represent the severity of the risk. All pretty self-explanatory.
- Low Risk
- Moderately Low
- Moderately High
The funds were classified into these categories based on their categories. Investors can select the risk they would be willing to take and choose the fund accordingly. The pictorial representation of these categories is known as the Riskometer.
The problem with this approach
While this approach was pretty successful in its implementation, some drawbacks and exceptions made this a less than ideal method of calculating risk. Paving the way for the new classification. The primary source of the problem was that it was a category-based Riskometer and not a fund-based Riskometer.
Grouping even slightly different things into the same categories poses some difficulties, especially in the case of financial vehicles such as mutual funds creates lots of complications. For example, a large-cap and mid-cap combination fund with a higher allocation to the large-cap equity stocks would be allotted to the same category as a large-cap and mid-cap fund with a higher allocation to mid-caps. The latter was far riskier than the former. But still, the old method would rate them as similarly risky.
The new method
To overcome these shortcomings, SEBI introduced a new risk measurement system in October 2020. Coming into effect from January of 2021, these changes improved the previous framework and redesigned the Riskometer with new guidelines.
It would be beyond the scope of this article to explain the 20-page article published by SEBI. But, to put things shortly, we can say that the algorithm takes care of almost every factor to give you a concise idea of the risk associated with the fund.
How risk value is calculated
The new guidelines demand that fund houses evaluate and report the fund’s risk level monthly to the investor. Based on multiple factors depending on the security of the investment, e.g., equity, debt, derivatives, foreign securities, etc. The guidelines also request that the underlined securities of the fund shall be assigned the values of multiple parameters. Risk will be calculated based on these values.
The average market capitalization value, volatility value, and impact cost value will mean the risk value of an equity portfolio.
While the average credit risk value, interest rate risk value, and liquidity risk value will determine the risk value of a debt portfolio.
How to read Riskometer
The new Riskometer introduced a “very high” category and the last five categories that would indicate the extreme volatility of the fund.
The pictorial representation of the new Riskometer features six levels, each associated with a colour or number or both, ranging from Green or <1 for low risk to dark red or >5 for the very high-risk category. The position of the needle of the Riskometer determines the level of risk associated with the fund.
Risk profiling of investors
The willingness and ability of an investor to take risks can be termed as the risk profile of the individual. The risk profile can be determined by the capacity of taking risks, the tolerance against risk, and the willingness to take the risk.
Profiling your risk-taking ability will help you select the right mutual funds that fit exactly as per your risk profile. The risk levels are associated with the returns. If you take low risk, the chances of you getting a high return from your investment are pretty low when you compare it with high risk, high return funds.
A mutual fund house or the distributor has various selection factors in creating the client’s risk profile. Once you know your risk profile, it gets easier to select the right funds according to your profile. The Riskometers can only help if you are aware of your risk profile.
Effectiveness of the new calculation method
Overcoming the drawbacks and limitations of the old Riskometer, the new Riskometer is easy to understand, simple, concise, beginner-friendly, and thorough. The thorough algorithm makes sure that the fund is always accurately risk labeled.
The new Riskometer allows for a clearer understanding of the risk involved in investing in a particular fund. The beginner-friendly nature and the compulsion on the fund house to periodically update the risk level are some of the highlighting features of the new method. Combined with a transparent and clear update to the user means that the investor will be fully aware of their investment. And always reminded of any changes in the risk level of the fund.
The monthly update and the risk disclosure on 31st March of each year to the risk level means that the risk level will always be up to date. And the investor will always know of that as opposed to the static assumption of the previous method.
Limitations of the new method
While the new method addresses the main issues concerning the last one, there are still a few areas to improve. The notable ones are as follows:
Practically, almost all equity funds are labeled as ‘high risk’ funds, without a clear distinction between the safer large-cap funds and relatively riskier small-cap funds. It is fair to assume that this is not an ideal situation, and there should be at least some form of distinction between such cases.
As it uses simple averaging, it may not capture the risks entirely. For example, suppose a fund has 95% AAA-graded securities and 5% AA-graded securities. In that case, it is highly possible that the risk level may not be representative of the absolute risk level of the fund.
Making the right decisions in the Mutual Fund market or avoiding the wrong moves is important for a new investor. The new method of calculating risk greatly benefits new investors avoid making the wrong choices at the beginning of their investment journey.
While the new method may not be the perfect solution, it is the best Riskometer we have ever had, and it is the closest thing we have to perfect risk management and representation guidelines. With each amendment, it will only improve with time and get better and better.
It should be particularly mentioned that the new form of the Riskometer is a massive upgrade over the previous version and makes the profiling and risk labelling much easier, comprehensive.
Overall, the new method is helpful while being a massive upgrade over the last one. And, with a few more tweaks, it can build a robust risk assessment system that will save time, resources, and wrong moves of many investors.