SEBI Says Mutual Funds Must Assign Risk Label To Every Scheme

The Securities and Exchange Board of India has issued new norms that will require mutual funds to label each of their schemes based on the blended risk of the securities—both debt and equity—held in their portfolios.

The new norms, which were decided upon based on the recommendations of the Mutual Fund Advisory Committee, will come into force on Jan. 1, 2021, but can be implemented before that date, the market regulator said in a circular on Oct. 5.

Mutual funds at present must assign a “risk-o-meter” label to a scheme based on the perceived risk of the category of the scheme. For example, a credit risk fund of ICICI Prudential Mutual Fund, which is a debt mutual fund scheme that invests primarily in riskier, lower-rated corporate debt, would bear the label of “moderate risk”, because that's the perceived risk of the category.

Starting Jan. 1, that's set to change. Mutual funds will have to assign a risk level to debt securities in three broad categories—credit risk, interest rate risk, and liquidity risk.

In the credit risk category, a value is assigned based on the credit rating of a debt security. The lowest risk weightage of “1” is given to a government security or a AAA-rated corporate bond. The risk weight is inversely proportional to the rating of the paper. Unrated securities are given a risk weight of “11” and those below investment grade “12”.

In the interest rate risk category, the Macaulay duration, or the weighted average term to maturity of the cash flows from a debt security, is used to assign a risk weight value. On the lowest end of the risk weight spectrum, debt papers with a Macaulay duration of less than or equal to six months are assigned a risk weight of “1”. Debt securities with a Macaulay duration of more than four years are given a risk weight of “6”.

The liquidity risk of a debt security is determined, and a risk weight assigned, based on its credit rating and whether it's listed on the exchanges. Higher-rated, listed debt securities are assigned a lower risk weight, while lower-rated unlisted securities get the highest risk weight.

The final risk weight of a debt mutual fund scheme is the weighted average of the scores in each category of risk. This final risk determines where on the risk-o-meter a scheme falls. Those with a weighted average risk of less than or equal to 1 are considered “low” risk, those above 1 and less than or equal to 2 are “low to moderate”, above 2 and less than or equal to 3 “moderate”, above 3 and less than or equal to 4 “moderately high”, and above 4 and less than or equal to 5 “high”. Those schemes that have a weighted average risk of over 5 will have to be categorised as “very high” risk.

For instance, if the weighted average credit risk, liquidity risk, and interest rate risk of a credit risk fund stand at 4, 4, and 4, respectively, then based on the scale prescribed by the SEBI, the risk-o-meter rating of the fund will stand at 4, which is “moderately high risk”.

What's more, as a likely consequence of the problems faced by Franklin Templteton Mutual Fund earlier this year, the SEBI has said that liquidity risk will trump the other two risks for debt mutual fund schemes. If the weighted average liquidity risk of a debt mutual fund scheme is higher than its credit and interest rate risk, then the liquidity risk will be used to determine the risk-o-meter reading of the scheme.

In the earlier illustration, if the credit risk, liquidity risk and interest rate risk of the credit risk fund had read 4, 5, and 4 respectively, then the risk-o-meter rating would stand at 5, which is high risk.

Changes To Equity Schemes

The risk assigned to equity mutual fund schemes will also change based on the composition of each scheme. Similar to the categories of risk assigned to debt securities, the SEBI has asked mutual funds to assign risk weights to shares based on market value, volatility, and impact cost value, which is a measure of liquidity.

Mutual Funds Must Regularly Update Risk-o-Meter

The market regulator has further stipulated that mutual funds must update the risk-o-meter in each of their schemes on a monthly basis, and display these on their websites within the first 10 days of the month. Mutual funds will also have to notify unitholders of any change in the risk-o-meter of schemes through an e-mail or SMS.

Additionally, mutual funds must inform unitholders at the end of a financial year of the number of times the risk-o-meter has been changed.

Advisors' Take

The introduction of scheme-wise risk labels for mutual fund schemes is a welcome move, according to Harshvardhan Roongta, certified financial planner and co-founder of Roongta Securities.

“The risk-o-meter on each scheme within a category will help an investor decide on investments in a better manner, so that the blended risk taken at the portfolio level is measured correctly,” he said.

Agrees Mrin Agarwal, licensed financial advisor and founder of Finsafe. “There's now a standard methodology for calculating the risk to the investor in each mutual fund scheme,” Agarwal said. “This is a welcome step, because it makes the risk categorisation for investors much clearer.”