New Riskometer in Debt Mutual Funds – Is it really measure the risk?

Continuation of its product labeling improvement, SEBI came out with one more circular on 5th October 2020 with regard to a new way of Riskometer. Also, this time in detail SEBI mentioned the new Riskometer in debt mutual funds and how it should be arrived at. Let us see whether it serves any purpose to the investors or not.

If you see the both Riskomter of which was launched in 2015 to the one which is launched in 2020, you notice how they look like as below.

New Riskometer in Debt Mutual Funds - Old Vs New

You noticed that the earlier “Moderately Low” was replaced with “Low to Moderate” and included one more risk category i.e “Very High”. Also, the calculation of risk was changed now and it made public for all of us to understand how it is calculated.

As per the new Riskomter, Risk-o-meter shall have following six levels of risk for mutual fund schemes :-

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

Few points to note which are mentioned in SEBI circular are as below :-

# Based on the scheme characteristics, Mutual Funds shall assign a risk level for schemes at the time of launch of scheme/New Fund Offer.

# Any change in risk-o-meter shall be communicated by way of Notice cum Addendum and by way of an e-mail or SMS to unitholders of that particular scheme.

# Risk-o-meter shall be evaluated on a monthly basis and Mutual Funds/AMCs shall disclose the Risk-o-meter along with portfolio disclosure for all their schemes on their respective website and on AMFI website within 10 days from the close of each month.

# Mutual Funds shall disclose the risk level of schemes as on March 31 of every year, along with the number of times the risk level has changed over the year, on their website and AMFI website.

# Product label must also disclose in SID, KIM and Common Application Form.

# Change in risk-o-meter will not be considered as a Fundamental Attribute Change of the scheme in terms of regulation 18(15A) of SEBI (Mutual Fund) Regulations, 1996.

# This new Riskometer will come into effect from 1st January 2021.

New Riskometer in Debt Mutual Funds – Is it really measure the risk?

In this post, let us discuss on the new riskomter in Debt Mutual Funds and how it really help you to measure the risk.

The calculation of Riskomter in Debt Mutual Funds is based on Credit Risk, Interest Rate Risk and Liquidity Risk. The risk value for the debt portfolio shall be a simple average of credit risk value, interest rate risk value, and liquidity risk value. However, if the liquidity risk value is higher than the average of credit risk value, liquidity risk value, and interest rate risk value then the value of liquidity risk shall be considered as the risk value of the debt portfolio.

# Credit Risk

Here, credit risk was classified into 12 categories. The G-Sec/AAA/SDL/ TREPS is assigned the value of ONE. Same way, unrated and below investment grade is rated as 11 and 12 respectively.

Based on the weighted average value of each instrument (weights based on the AUM), the credit risk value of the portfolio shall be assigned. The price of the debt instrument to be considered for calculating AUM shall include the accrued interest i.e. dirty price. The credit rating of the instrument as on the last day of the month shall be considered.

# Interest Rate Risk

Interest rate risk will be valued using Macaulay Duration of the Portfolio. Macaulay Duration of the portfolio like 0.5 is given the interest rate risk value of 1 and > 4 has the highest interest rate risk value of 6. For the calculation of interest rate risk purpose, Macaulay Duration of an instrument as on the last day of the month shall be considered.

# Liquidity Risk

For measuring liquidity risk of the schemes, listing status, credit rating, structure of debt instruments is considered. The liquidity risk value of securities like TREPS/G-Sec/AAA rated PSU/SDLs are considered as 1 and the highest value is 12 for BBB rated securities.

Based on the above risks, the mutaul fund company has to assign the rating as below.

Mutual Funds Riskometer Risk Values

SEBI gave an illustration of this as below:-

Assume that a fund is holding 10 securites and weightage of the same along with credit rating is mentioned.

Calculation of Riskometer in Debt Fund

Based on the above portfolio, the credit risk, interest rate risk and liquidity risk can be calculated as below.

Now to arrive at the weighted average of all these risks, you can calculate the same as below.

Calculation of Riskometer

The simple average of the above three parameters comes out to 3.8 ([3.5+3+4.8]/3). Since the liquidity risk value of 4.8 is higher than the average value of the above three parameters i.e. 3.8, the risk value assigned to the scheme will be 4.8. Hence, the risk level as per Risk-o-meter is High.

I hope you have a simple mathematical calculation to arrive at this Riskometer number. Now let us see whether it is really useful for understanding the risk involved in debt mutual funds.

# Interest Rate Risk:- This calculation again considering the AVERAGE MACAULAY DURATION of the portfolio. However, do remember that average is not applicable to individual securities held by the fund manager. The average Macaulay duration may be low but few securities may have almost double than the actual average Macaulay duration. Hence, I will not trust on this AVERAGE concept. Refer my latest posts on why we must not consider the term AVERAGE in debt funds “Whether Banking and PSU Debt Funds are SAFE?” and “HNIs or Institutional Investors – Retail Debt Mutual Fund Investors SILENT enemies“.

# Credit Risk :- Assume that the fund is holding 90% AAA-rated bonds (where the credit risk value is 1) and rest in BBB+ rated bonds (where the credit risk value is 10). Now as per the above calculation, if we do the credit risk value of the fund, then we have to do as 0.9*1+0.1*8=1.7. Based on the weightage, it will give you an indication. But it will show you the real risk of 10% of the portfolio which is in BBB+ rated bonds.

# Liquidity Risk:- Now in case of liquidity risk if we take the above example of 90% in AAA-rated bonds (where the liquidity value risk is 1) and 10% in BBB+rated bonds (where the liquidity value risk is 9-for assumption purpose), then the overall liquidity risk value is 0.9*1+0.1*9=1.8.

If we go with this assumption of average Macaulay duration of the fund as within 1 to 2 years, (interest rate risk value is 3), credit risk value as 1.7, and liquidity risk value as 1.8, then the average of all these three values is 2.16 Riskometer total value. which states that the fund is falling under the “Moderate” category of risk of funds. But your 10% of the portfolio may be under risk.

Hence, we can form many such combinations of calculations to show different results to the funds than the true risk involved in the fund. Even though it may give us a glance of risk. This Riskometer will not give you a clear picture.

Even though it is a good move from SEBI’s regulatory perspective that if any change happened, then mutual fund companies have to inform the investors immediately, I don’t think it will give us a clear picture of the risk involved in debt funds.

Conclusion:-How many mutual fund investors know that there is a Riskometer is the question we have to ask ourselves. The second important aspect is that, even though it will give you the small hint, but will not give you the clear picture of the risk. Hence, relying on this Riskomter to invest may be harmful for you. Dig deeper into the portfolio and watch the portfolio holdings regularly (especially when it comes to debt funds).

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