Mutual Fund Riskometer – Old Wine New Bottle

The new Riskometer for Mutual Funds is an old wine in new bottle. SEBI (Securities and Exchange Board of India) will replace the existing colour coding system for mutual funds with new riskometer. The new product labelling system will be implemented from 1st July, 2015. If any fund house would like to implement the new riskometer before 1st July, 2015 then they are free to do so. Riskometer will be applicable for both old and new mutual fund schemes.

Existing Colour Coding System

Mutual fund investors must be familiar with the following colour coding picture

It basically shows the risk level associated with a particular mutual fund scheme. Normally you will observe that Debt Mutual Funds with low risk are labelled as BLUE. Balanced funds and Monthly Income Plans with moderate risk are labelled as YELLOW. Whereas all Equity funds with high risk are blanketly labelled as BROWN. Its a no brainer and existing colour coding system does not add any value to the investor. I will explain it in details in following sections.

The New Riskometer

Here comes the new riskometer, which will be visible from 1st July, 2015. The following Riskometer will be disclosed on the Front Page of the NFO (New Fund Offer) or wherever scheme details/information will be advertised/declared/disclosed/published.

*Image Courtesy: Securities and Exchange Board of India (SEBI)

Now, you compare colour coding system and new riskometer, there are 2 changes. First, the two additional risk levels are incorporated in existing system. Second, the colour coding risk level will shift to 180 degree black & white graphic scale with arrow based risk depiction. The new risk levels are as follows along with probable mutual fund categories

1. Low – Principal at low risk :: Debt Funds like Short Term, Liquid, Ultra Short Term

2. Moderately Low – Principal at moderately low risk :: Debt Funds like Gilt Funds, Income Funds, Long Term

3. Moderate – Principal at moderate risk :: Balanced Funds, Monthly Income Plans

4. Moderately High – Principal at moderately high risk :: ETF’s, Large Cap, Diversified

5. High – Principal at high risk :: Sector Specific Funds, Mid Cap, Small Cap

As usual my friends from personal finance space are gung-ho about new riskometer and i can see a flood of posts on how new riskometer will be beneficial for investors. In my opinion, this initiative is only going to help the mutual fund industry. Let’s check out

How new Riskometer will help the Fund Houses?

1. Colour ads: The mutual fund houses will be the biggest beneficiary as they will save a lot in marketing cost. With colour coding system, it was compulsory to publish colour ad/brochure/dangler/Brochure/Scheme Details. This could have been the most compelling reason for SEBI to come out with new black and white riskometer vis a vis colour coding system. Under new system, black and white ad will suffice. Secondly, colour coding has high visibility compared to black and white riskometer. Mutual fund houses must be celebrating and the poor investor is happy with the inclusion of 2 more risk levels.

2. Confusion is the best strategy: More Risk Levels means more confusion. RISK is relative and subjective term. Any parameter to define the risk, be it a colour coding or riskometer is for informed decision-making. These parameters neither eliminate the risk nor reduce the risk. Moreover, Risk is always relative and more of a perception. For example, under colour coding system Large Cap Mutual Funds were tagged under BROWN i.e. Principal is at High Risk. Now under the new system, the risk level of Large Cap Mutual Funds will be Moderately High. In relative terms, Large Cap Mutual Funds will be less risky on Riskometer compared to Colour Coding system. The fact of the matter is that nothing has changed on the ground, principal of investor is anyways will be at high risk. From the marketing perspective, it is beneficial for some Large Cap Mutual Funds as they will be less risky from 1st July, 2015 :). Once again, i would like to congratulate fund houses for the implementation of new system

How Investor is being cheated?

1. Perception of Risk: I fail to understand how new Riskometer will help in informed decision-making and mitigate risk. Perception of risk should be linked to the performance of the mutual fund scheme. Within a particular risk level say High Risk, we will have a mutual fund scheme with a single digit return in last 1 years i.e. 9.8%. On the other hand, a scheme with same risk level has delivered 3 digit returns i.e. 104%. The investment strategy of the mutual fund scheme determines the level of risk. It’s a state of confusion for the investor as at the same risk level, returns vary drastically. Investor should focus on selecting right mutual fund depending on his investment objective.

2. How Risk Level is calculated?: You must be wondering how the risk is calculated. Just to add that risk level is assigned on the basis of the best practice guidelines issued by Association of Mutual Funds in India (AMFI). There is no scientific way to calculate Risk level. In short, we are treating everyone with the same stick. The worst part is that we are suggesting an investor to invest based on the risk rating which is frivolous and vague.

3. Relative Risk: As i mentioned that the risk is relative which only an informed investor will understand. For example, there are 2 types of Balanced funds i.e. Debt oriented and Equity Oriented. In all probability, the risk level of both these categories will be Moderate under the new system. The fact of the matter is that Balanced Fund – Equity Oriented is riskier compared to Balanced Fund – Debt Oriented. Therefore, through riskometer we cannot quantify the risk associated with 2 sub-categories of Balanced Funds.

Summary: The role of a regulator should be of a watchdog and being investor friendly especially in the field of finance. Reason being, the investor is being cheated due to financial illiteracy and unavailability of “financial advisers” in the true sense. Mis-selling is very common in the financial sector and on top of it, such misleading risk ratings will further confuse the investor.

The new Riskometer is an act of tokenism from the regulator. Instead, we need a regulatory framework to address the issues of mis-selling. The mutual fund schemes are being advertised in a misleading way. For example, a specific period is identified i.e. from the time of low till the time of peak when the returns are highest for obvious reasons. It’s a common sense that returns will be highest from trough to crest. The investor is being trapped by misrepresentation of facts.

At the end of the day, everyone knows that if i am investing in equity then my risk levels are high. The shift from colour coding to Riskometer will not make any difference in the life of an investor. This new riskometer is only useful for 1st-time investors, who are yet to grasp the ABCD of the financial world. This new class of investors is mostly responsible for the monthly target achievement of Relationship Manager or Mutual Fund Distributors.

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