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The role of the Risk-o-meter in assessing mutual fund investments

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The mutual fund Risk-o-meter is an indispensable feature for investors, offering a clear and standardised way to assess the risk levels associated with mutual fund schemes. Introduced by the Securities and Exchange Board of India (SEBI), it has enhanced transparency and enabled investors to get a clear visual representation of the level of risk involved in a mutual fund scheme. Whether you’re investing directly in mutual funds or through distributor, understanding the mutual fund scheme riskometer is crucial for making informed decisions.

  • Table of contents
  1. Riskometer meaning and advantages
  2. History of Risk-o-meter
  3. Riskometer risk levels and what they imply
  4. Types of mutual fund schemes and their riskometer
  5. Other types of risks in mutual funds
  6. Important considerations

Riskometer meaning and advantages

A Risk-o-meter is a standardised visual representation of the risk associated with a mutual fund scheme. It resembles a speedometer and categorises funds into six levels of risk: Low, Low to Moderate, Moderate, Moderately High, High, and Very High. Each level corresponds to the potential risk of losing the principal amount invested in the fund.

By providing a quick snapshot of risk levels, the mutual funds riskometer enables investors to align their choices with their financial goals and risk appetite.

This risk level is dependent upon factors such as asset allocation, vulnerability to market volatility and investment strategy. Typically, equity-oriented schemes may fall into the very high category, while debt mutual funds can range from low to moderately high (some may be high risk).

This riskometer must be prominently displayed on all scheme-related information and documents of a mutual fund scheme, application forms, and all advertisements or communications related to it.

History of Risk-o-meter

The Risk-o-meter was introduced by SEBI in 2013 as part of its efforts to improve transparency in mutual fund investments. Initially, it categorised funds into three levels using color codes: low (blue), medium (yellow), and high (brown).

To give investors a clearer picture, SEBI in 2015 revamped the mutual fund scheme riskometer and expanded it to five levels: Low, Moderately Low, Moderate, Moderately High, and High. The upgrade allowed for better differentiation between funds based on their risk profiles.

In January 2021, SEBI further enhanced the system by adding a sixth level – Very High – making it even more comprehensive. This latest version considers multiple factors like asset type, market conditions, and fund strategy to provide a more accurate assessment of risk.

In 2024, SEBI additionally specified a colour code for each level of the riskometer, making it even easier for investors to assess the risk level of a scheme at a glance.

Riskometer risk levels and what they imply

The riskometer risk levels are categorised into six tiers.

Risk level Color code Description
Low Irish green Low risk; suitable for conservative investors seeking minimal impact on capital invested.
Low to moderate Chartreuse (yellowish green) Slightly higher risk; suitable for moderately conservative seeking relative stability if capital.
Moderate Neon yellow Suitable for those willing to take moderate risks for a better return potential.
Moderately high Caramel Higher risk; suited for investors with some tolerance for market fluctuations.
High Dark orange Significant risk; appropriate for investors seeking high returns over the long term.
Very high Red Very high risk; designed for experienced investors with substantial risk appetite.

These levels provide clarity on where a particular mutual fund stands in terms of its potential risks and rewards.

Types of mutual fund schemes and their riskometer

The mutual funds riskometer evaluates specific types of risks based on the nature of the mutual fund.

  • Equity funds: High exposure to stocks and market volatility makes these funds range typically Very High risk
  • Debt funds: Relatively lower risk but subject to interest rate and credit risks depending on the instruments they invest in. Can range from Low to Moderately High. Credit risk funds may also entail High Risk.
  • Hybrid funds: A mix of equity and debt components leads to a more balanced risk-return potential profile. Can range from Moderate to Very High depending on the debt-to-equity ratio. An arbitrage fund may qualify for the Low Risk category.
  • Sectoral/thematic funds: Concentrated exposure to specific sectors typically results in a risk rating of Very High.
  • Liquid funds: Typically Low or Low-to-Moderate risk due to investments in high-quality, short-term debt securities.

A scheme’s riskometer may change with a shift in the underlying portfolio. In such an event, a mutual fund company must notify investors of this via notices, email, SMS etc.

Other types of risks in mutual funds

Here are some of the factors that influence risk in mutual funds:

  1. Market risk: The possibility of fluctuations due to overall market downturns.
  2. Liquidity risk: Difficulty in redeeming investments due to low market activity.
  3. Credit risk: The chance that issuers of debt instruments may default or interest payments or principal repayment.
  4. Interest rate risk: The risk of a change in interest rates impacting the market value of fixed-income instruments.
  5. Inflation risk: The erosion of purchasing power due to rising inflation.
  6. Managerial risk: Dependence on the expertise and decisions of fund managers.
  7. Regulatory risk: Changes in laws or regulations affecting fund performance.

This classification aids investors in choosing funds that align with their financial objectives.

Important considerations

While the mutual funds riskometer is an invaluable tool, it should not be used in isolation when making investment decisions. Investors must also consider other factors such as:

  • Expense ratios
  • Fund manager expertise
  • Asset allocation
  • Investment horizon

Moreover, regular re-evaluation is essential as personal financial goals and market conditions evolve over time.

Conclusion

The introduction of the Mutual Funds Riskometer has simplified mutual fund investments, increased transparency and aided informed decision-making. By categorising funds into six distinct levels of risk, it helps investors align their choices with their individual financial goals and risk tolerance. However, while it is an excellent starting point, investors must delve deeper into other aspects like historical performance and expense ratios before committing their money to a scheme. As mutual funds remain subject to market risks, understanding tools like the riskometer can significantly enhance an investor's ability to navigate these uncertainties effectively.

FAQs:

How is riskometer determined?

The risk level of a mutual fund as depicted on the Risk-o-meter is based on various parameters such as asset allocation, credit quality of underlying securities, interest rate sensitivity, and liquidity factors.

Is it safe to invest in Very High-risk mutual funds?

No investment is safe, and Very High is the riskiest category. It indicates that the principal is at very high risk. Such funds are suitable for investors with a high tolerance for volatility and a long investment horizon.

Are low-risk mutual funds safe?

No, they are not safe. Low-risk mutual funds are relatively more stable but not entirely free from risks such as inflation or credit defaults.

How do you measure risk in mutual funds?

Risk in mutual funds can be measured using tools like the Sharpe Ratio, Beta Coefficient, Standard Deviation, Alpha, R-Squared etc.

How do you use a riskometer?

A riskometer is a visual guide that can be easily interpreted based on its labelling and colour codes (detailed in the article above). It is prominently displayed on all scheme-related documents, product communication material and application form.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.

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