Mutual Fund Riskometer

Investing in mutual funds can be risky.

And while the definition and tolerance of risk may differ across investors, it is important to have a standard measure of risk. This is the purpose of the mutual fund riskometer.

Before 2015, the riskometer was simply a colour code system with no graphical representation:

In April 2015, the SEBI (Securities and Exchange Board of India) introduced the ‘riskometer’, which would graphically represent the risk of each mutual fund category. These levels, in order of increasing risks, were:

1. Low - principal at low risk
2. Moderately Low - principal at moderately low risk
3. Moderate - principal at moderate risk
4. Moderately High - Principal at moderately high risk
5. High - principal at high risk

Enhancements in the riskometer came in 2020-21 again. In this article, we discuss these enhancements, how the riskometer works and how to interpret it.

What is the Mutual Funds Riskometer?

Riskometer communicates the risks of investing in a mutual fund scheme through a simple graphic. More precisely, it communicates the risk your capital/investment is subject to when you invest in a particular scheme.

Presently, the riskometer has 6 levels of risks and looks very similar to a car's speedometer.

Just as the speed of a car impacts the safety of the passengers in the car, the risk level of a mutual fund scheme impacts the safety of money invested in it.

As we mentioned, the SEBI introduced enhancements in the riskometer in 2020 and the riskometer you see above is the latest as applicable in 2023. The SEBI directed these enhancements to make the riskometer more nuanced and useful.

The Enhanced Riskometer of 2021

The SEBI laid down the following rules regarding the riskometer in 2021:

• Sixth level of ‘Very High Risk’ added in the riskometer
• Compulsory monthly disclosure of riskometer by AMCs
• AMCs must communicate changes in the risk level to investors

But most importantly, SEBI laid down rules on the assignment of risk levels to mutual fund schemes for their equity and debt portfolios (whichever is applicable). This was important because the earlier riskometer would represent the risk level of the mutual fund category and not necessarily the scheme’s risk.

For example: The older riskometer (introduced in 2015) would have the same risk level for all mid cap fund seven if different mid cap schemes took different levels of risk. The enhanced riskometer now works such that different mid cap schemes can have different risks and represents each scheme's actual risk.

We discuss these rules in brief in the next section.

How Does the MF Riskometer Work?

SEBI's riskometer uses a quantitative methodology to determine the level of risk associated with mutual fund investments. This means the riskometer is standardised and not subject to different interpretations.

The riskometer considers various factors while measuring the risks of equity and debt portfolios of schemes. We discuss some of the key factors and their treatment by the methodology in the following paragraphs.

Please note that the below is a simple explanation of the methodology and the actual methodology is more sophisticated and quantitative in nature.

Riskometer For Equity Schemes:

Risk in equity schemes mainly arises from:

1. Size of the company the scheme invests in
2. Volatility or fluctuations in the security price
3. Impact cost that measures liquidity

Market capitalisation

Market capitalization is an indicator of the size of a company measured through the total value of its outstanding shares. 

Larger companies (also known as large caps) have stable businesses and predictable cash flows. They can withstand bad economic conditions for a long time. Hence, they are considered to be safer than mid caps and small caps.

The higher the market capitalization, the lower the risk.

Volatility

Volatility refers to the daily fluctuation in the price of a stock. Some stocks are stable and don’t move much on a daily basis, whereas others may move violently on most days.

The higher the volatility, the higher the risk.

Impact Cost (Liquidity Measure)

When buying/selling large quantities of stock, mutual fund schemes may not be able to execute the transactions for all the stocks at the prevailing price.

Suppose a fund manager wants to buy 1,00,000 stocks of company A and sees that 75,000 shares are available at Rs. 100, but the next 25,000 shares are available at Rs. 120. He would have liked to buy all shares at Rs. 100 but can’t because the trading volume is low.

The extra price he has to pay to procure the shares is called impact cost, which is a measure of liquidity or how quickly you can convert something into cash without losing value.

Low trading volumes increase the impact cost.

The higher the impact cost, the higher the risk.

Riskometer For Debt Mutual Funds:

Risk in debt schemes mainly arises from:

1. Default by bond issuer
2. Change in interest rates
3. Lack of liquidity in the bond markets

Credit Risk

Credit risk is the risk that the bond issuer (borrower) will default on their debt obligations and not pay the principal/interest.

The higher the credit risk, the higher the risk associated with the debt fund. 

Interest Rate Risk

A change in interest rates impacts the price of bonds. If the interest rates go up, bond prices go down, and vice versa. The impact of interest rates on bond prices is measured through the ‘duration’ of bonds.

The higher the duration of the bond, the higher the risk.

Liquidity Risk

Liquidity refers to how quickly something can be converted into cash without losing value. Bonds that have low demand are prone to liquidity risk, which increases the overall risk of the debt fund that has invested in them.

The lower the liquidity, the higher the risk.

How to Interpret the Riskometer?

Riskometer has 6 categories ranging from ‘Low Risk’ to ‘Very High Risk’ as follows:

1. Low Risk
2. Moderately Low Risk
3. Moderate Risk
4. Moderately High Risk
5. High Risk
6. Very High Risk

Different investors may perceive investing risk differently. Hence it is important to establish what the riskometer actually indicates.

The risk indicated by the riskometer is losing your principal or investment amount.

If a scheme has a ‘Moderately Low Risk’ level, it means that you are at a moderately low risk of losing your investment amount partially/fully if you invest in the scheme.

Benefits of Riskometer in Mutual Funds

The riskometer is a very good attempt at educating investors about the risks of investing. Here are a couple more benefits of the riskometer: 

Standardised approach

The riskometer is a standard and simple approach to communicating the level of risk associated with mutual fund schemes. The standard methodology enables investors to compare the risk levels of different fund schemes and make a more informed decision.

Enhanced transparency

The SEBI riskometer circular requires AMCs to disclose each scheme's risk level and update it every month. This helps keep matters transparent between the AMC and the investors.

Shortcomings of the Riskometer

While the enhanced riskometer introduced in 2021 is a much better iteration than the older riskometers, it is still not perfect. We see 3 shortcomings in the riskometer as of 2023:

Most Equity Funds are ‘Very High Risk’ now

Because of how the methodology is structured, most equity funds fall in the ‘Very High Risk’ bucket. But seasoned investors will realise that this is not the case.

Even within the universe of equity funds, different funds have distinctly different levels of risk. 

For example, Large cap funds are considered to have the lowest risk among equity funds, whereas sectoral/thematic funds are considered to have the highest risk. But the riskometer methodology assigns both of them ‘Very High Risk.’

Doesn’t Help in Mutual Fund Selection

The riskometer is an attempt at standardising risk levels across mutual fund schemes.

You cannot rely on it completely to select a mutual fund scheme or construct a mutual fund portfolio.

It is best to seek expert guidance while making mutual fund selection/investment decisions.

Doesn’t Take into Account Some Key Risks

It is well known that a concentrated portfolio (a portfolio with only a few stocks and/or bonds) is riskier than a well-diversified portfolio of stocks and/or bonds.

Investors invest in actively managed mutual fund schemes to beat the benchmark index of the scheme or simply the inflation rate.

Concentration risk and the risk of the fund not beating the benchmark/inflation rate are some key risks that the riskometer doesn’t consider.

Mutual Fund Riskometer FAQs

How to find a mutual fund's riskometer rating?

The mutual fund riskometer can be found on the website of the mutual fund house or the Association of Mutual Funds in India (AMFI) website. From January 1, 2021, all mutual funds houses in India have been instructed to update the riskometer every month.

Is the riskometer a reliable tool for measuring mutual fund risk?

It is important to note that the mutual fund riskometer, although standardised and helpful is not perfect and has its limitations. The riskometer does not consider an individual's unique financial goals and health. So merely relying on the riskometer and investing in mutual funds is an investment strategy that may backfire.