Deciphering Mutual Fund risk levels with the risk-o-meter

Mutual funds, as you may be aware, are financial instruments that pool money from various investors and invests in assets such as equities, bonds, money market instruments, and more. Consequently, these funds carry risks inherent to the nature of the assets in which they are invested.

Take, for example, a scenario where a mutual fund concentrates its investments in equities. In this case, it inherently assumes a higher level of risk compared to a mutual fund predominantly invested in debt fund.

Many investors are unaware of the risks associated to mutual fund investments, often assuming that all mutual funds carry an equal level of risk. Fortunately, SEBI has taken a proactive step by mandating the inclusion of a risk-o-meter in every mutual fund scheme document. This empowers investors with a tool to understand and gauge potential risks, enabling clearer and more informed decision-making.

What is a risk-o-meter?

The risk-o-meter is a standardised risk measurement scale introduced by the Securities and Exchange Board of India (SEBI) for Mutual Funds. It stands as a crucial tool for investors. The innovation lies in its unique approach to risk grading. Unlike its predecessor, which simply correlated fund categories with different risk grades, the updated risk-o-meter assesses risks based on individual assets held within a fund. This shift represents a move towards a more realistic risk evaluation, considering the actual risks associated with the fund's owned assets.

Also Read: All You Need To Know About Types Of Mutual Funds

Breaking down risk into six distinct levels, the risk-o-meter serves as a comprehensive guide:

1. Low: Minimal risk suitable for individuals aiming for capital protection to some extent.

2. Low to Moderate: Tailored for investors willing to assume a moderate level of risk for medium to long-term returns. Many ultra-short duration funds fall into this category.

3. Moderate: Ideal for portfolio diversification with some level of risk. This category often includes dynamic bond funds.

4. Moderately High: Designed for investors with a slightly higher risk tolerance for potential higher growth or profitability, albeit with increased uncertainty and volatility.

5. High: Funds in this category are suitable for those prepared to undertake substantial risk for the prospect of significant gains.

6. Very High: Reserved for risky funds that invest in volatile stocks or overseas mutual fund units. Geared towards investors seeking high-risk, high-reward investment opportunities.

How is the Riskometer for a scheme determined?

The riskometer aims to provide a comprehensive overview of the risk associated with the mutual fund scheme. It achieves this by assigning a risk score to each asset class held within the mutual fund scheme.

Risks associated with equities

For equities, every position within the portfolio receives a risk score determined by three primary factors:

Market Capitalization plays a significant role, with small-cap stocks deemed riskier than mid-cap stocks, and mid-cap stocks riskier than large-cap stocks. The risk value is recalculated every six months.
Volatility is a crucial factor, with stocks displaying substantial daily price fluctuations assigned higher risk values, assessed over the preceding two years.
Impact Cost or Liquidity is considered with stocks having low trading volumes undergoing significant price shifts during large transactions, elevating the impact cost and the corresponding risk value. This risk value is derived from the three-month average impact cost, encompassing the ongoing month's evaluation.

Also Read: Who should opt for Mutual Funds?

Risks associated with debt securities

The assessment of risk for debt securities involves several factors such as:

Credit Risk considers credit ratings of securities, with lower risk values for higher credit ratings (e.g., AAA/G-Sec/SDL/TREPS) and increased risk for below-investment-grade ratings due to the heightened likelihood of default.
Interest-Rate Risk is determined by the Macaulay Duration of the portfolio, with longer maturity bonds receiving higher risk values due to sensitivity to interest rates fluctuations.
Liquidity Risk assessment includes factors such as listing status, credit rating, and the structure of debt instruments.

Here’s an example of how a risk-o-meter helps to select a MF scheme based on your risk profile.

Investor's Profile	Objective	Investment Horizon	Risk Grade	Majority of Schemes in the Category
Preserving capital	Aiming for minimal risks with low returns	Short term	Low	Overnight Fund, Liquid Fund, Arbitrage Fund
Steady growth with limited risk	Willing to accept low risks for modest returns	Medium term	Low to Moderate	Ultra-Short Duration Fund, Low Duration Fund, Money Market Fund, Floating Rate Debt Fund
Moderately high return potential	Accepting moderate risks for comparatively higher returns	Medium term	Moderate	Banking & PSU Fund, Short Duration Fund, Medium Duration Fund, Corporate Bond Fund
Enhanced Growth with Managed Risk	Embracing high risk for the chance of higher returns	Long term	Moderately High	Medium to Long Duration Fund, Dynamic Bond Fund, Long Duration Fund, Gilt Fund, Conservative Hybrid Fund, Equity Savings Fund
Aggressive Growth	Seeking long-term growth with proportional higher risks	Long term	High	Balance Advantage Fund, Multi-Asset Allocation Fund, Aggressive Hybrid Fund, Gold/Silver ETFs,
Maximising Return Potential	Aiming for maximum returns with awareness of potential capital erosion	Long term	Very High	All types of Equity Funds

Note: This table serves as a representation, and risk-o-meter grades within the same category can vary. Therefore, thorough research and review of scheme documents are advised.

Other ways to measure the risks of mutual funds

Apart from the risk-o-meter, there are other important ways to assess risk. Here are three industry-accepted risk measures that can come in handy:

Beta

Beta assesses the relative volatility of a mutual fund's returns compared to its benchmark. If the beta of a mutual fund is 1, it means that the mutual fund will perform similarly to the benchmark returns.

Standard Deviation

In the context of a mutual fund, it reflects the level of volatility or risk associated with the fund. If a fund has a 10% average return and a 3% standard deviation. Roughly 68% of the time, its returns will fall between 7% and 13% (mean plus/minus 1 standard deviation). If we extend this to mean plus/minus 2 standard deviations, it covers 95% of the events.

Sharpe Ratio

The sharpe ratio is equal to the difference between the risk-free rate of return and the fund's total returns, divided by the standard deviation. It tells you whether a mutual fund's return has resulted from prudent investment decisions by the fund manager or from taking excessive risks.

Also Read: Investing in long-term Mutual Funds

Conclusion

In recent years, the Indian mutual fund industry has transformed significantly, driven by technological advancements and widespread use of digital channels. This growth can be attributed to regulatory controls implemented by SEBI. However, to thrive financially, consider factors such as risk tolerance, goals, time horizon, and asset allocation for a prosperous future.

Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.
Mutual Fund investments are subject to market risk, read all scheme related documents carefully. Axis Bank Ltd is acting as an AMFI registered MF Distributor (ARN code: ARN-0019). Purchase of Mutual Funds by Axis Bank’s customer is purely voluntary and not linked to availment of any other facility from the Bank. T&C apply.