New SEBI guidelines for risk scoring mutual funds

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“Never let a crisis go waste”.

SEBI has taken this adage seriously and come out with a comprehensive set of guidelines to communicate risk associated with mutual fund schemes.

Remember the image below. This is a RiskOMeter. You see it as a part of your mutual fund scheme factsheet.

Focused Multicap 35 riskometer

The unfortunate part is that no one ever paid attention to it – not the investor, not the advisor. No one one what it meant beyond the risk names – “High”, “Low”, “Moderate”, etc.

But you ask, what does “Moderately High” really mean?

Let me paint a picture. You are driving on the road. It’s slightly dark. After a few minutes, you get a vague feeling that a vehicle is approaching from the opposite side. You have but no idea of what size, at what speed and in which lane?

You know only when you make a deep swerve to the side and are saved by a hair split of a distance. Some one else may not be so lucky.

Phew! Hopefully, that is likely to change.

SEBI now wants mutual funds to do a more detailed quantitative exercise under the hood and use it to calculate risk scores for each scheme and then use that score to reflect in the risk-o-meter.

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With this, the next time you see a moderate risk on the riskometer, you will know what it truly means.

To make that possible, SEBI has given extensive guidelines for equity as well as debt schemes. For hybrids, they will use the 2 sets of parameters in conjunction to arrive at the risk score and hence the riskometer rating.

For debt funds, there are 3 key risks that need to be evaluated:

  • Credit Risk (based on credit ratings issued)
  • Interest Rate Risk (based on Macaulay’s Duration which measures interest rate sensitivity)
  • Liquidity Risk (based on what can stop an investment from being sold quickly)

In case of equity funds, the 3 key assessments are:

  • Market Cap (Large, Mid or small cap)
  • Volatility (based on daily volatility for last 2 years)
  • Impact cost (also a proxy for liquidity)

Similarly, gold, FOFs, REITs, InvITs, etc have been given separate attention as well.

There are clear categories and scores against each of the above parameters which then lead to a weighted score.

Interestingly, in case of debt funds, the liquidity score rules them all (the recent crisis weighs in heavily). If the average score of the 3 parameters is less than the liquidity score, then the liquidity score is taken as the risk score. (We will see what it means as we take up a case study)

In our post today, we will use 3 of our debt funds (1 liquid, 1 dynamic bond and 1 short term debt fund) and see where do they fall on the riskometer using the new risk scoring guidelines.

Higher the score, higher the risk

To read the detailed guidelines, click here.

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Fund 1: Parag Parikh Liquid Fund

Parag Parikh Liquid fund invests primarily in T-Bills with less than 91 days of residual maturity. It is one of the safest avenues to park short term money.

The fund’s current riskometer says “Low” risk. Let’s see if the new SEBI guideline confirms the same.

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Vipin Khandelwal

Vipin Khandelwal

Vipin is a SEBI Registered Investment Adviser. He works with investors to make better decisions and create behaviour alpha.
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