What is Riskometer in Mutual Fund?
Like all other investment vehicles, mutual funds include some degree of risk. Prior to investing, it is critical to weigh these risks. A mutual fund riskometer can assist you with it. Typically, investment decisions are made based on an investor’s risk tolerance levels. In their early or mid-twenties, a person may, potentially, take a more aggressive approach to investing in equities, whereas a retiree may prefer risk-averse fixed-income investments.
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The risk is determined by the mutual fund scheme’s underlying portfolio holdings. As a result, the risk indicated by the Risk-O-Meter is now at the fund level rather than the category level.
For example, suppose a Liquid Fund decides to absorb credit risk to boost its returns. In that case, the fund’s Risk-o-Meter will indicate a higher level of risk, even though the Liquid Fund category is designated as Low Risk.
For investor education purposes, the market regulator SEBI mandated all mutual fund houses to display a riskometer illustrating the five risk categories.
According to the standards, the colour codes must be presented on the front page of application forms with the scheme’s name. These colour codes will correspond to the scheme’s financial risk.
According to the SEBI circular, the use of colour codes to describe risk will be phased out in favour of a visual metre called the riskometer. The riskometer will accurately depict the level of risk in each given scheme.
How is Riskometer Determined for Equity and Debt Funds?
The risk level of the schemes is evaluated every month. It considers the securities in which the scheme invests, namely equities, debt, derivatives, and foreign securities. Furthermore, it also considers the AUM of the securities as of the last day of the month. According to SEBI criteria, a scheme’s underlying securities must be assigned a value for parameters such as volatility, credit risk, and so on, from which the risk level is determined.
Equity Mutual Funds
- Market Capitalization: The market capitalization of a stock helps in determining the risk levels. For example, a large-cap stock has a lower risk score than a mid-cap or small-cap stock. Similarly, small and mid-cap stocks have the highest risk score compared to large and mid-cap stocks.
- Volatility: Volatility accounts for the daily stock fluctuations. The greater a stock’s daily volatility, the greater is its risk. Thus, if a fund has highly volatile stocks, naturally, the fund is going to be a risky option.
- Impact Cost (Liquidity Measure): Certain stock prices fluctuate significantly due to huge transactions. This is frequently the case due to the low trade volume. As a result, if a large purchase transaction occurs, a fund manager may be forced to purchase the shares at a higher price than expected. And, if there is a large sell transaction, sell such stocks at a lower price than expected. This is referred to as the impact cost. Thus, if a stock has a low trading volume or liquidity, its impact cost increases. As a result, the greater the impact cost of the stock, the greater the risk value.
Debt Mutual Funds
- Credit Risk: Credit risk is the risk where the bond issuer defaults on its payments. The greater the credit risk, the more likely it is that the bond issuer will default on the loan. Thus, the greater the credit risk, the higher a debt fund’s risk score.
- Interest Rate Risk: Interest rates and bond prices are inversely proportional. In other words, as interest rates increase, the bond prices fall, and vice versa. The longer the tenure of a bond, the more sensitive it is to interest rate changes. As a result, the risk score of a debt fund is higher if it invests in bonds with longer maturities.
- Liquidity Risk: Liquidity refers to a bond’s ability to be easily sold. Thus, a debt fund’s risk score will be high if it invests in illiquid debt products with little market activity.
Categories of Mutual Fund Riskometer
Earlier, the riskometer had five risk levels: Low, Moderately Low, Moderate, Moderately High, and High. Recently, SEBI has introduced another level which is ‘very high risk’.
Following are the categories of mutual fund riskometer in detail:
|Low-risk level funds are suitable for investors willing to take minimal risks. They will receive minimum to no returns.
|Low to Moderate Risk
|Moderately Conservative Investors
|Low to moderate risk funds are suitable for investors willing to take on a small amount of risk to earn a profit over the medium to long term.
|Moderate risk funds are suitable for investors willing to accept a moderate level of risk in exchange for potentially better profits over the medium to long term.
|Moderately High Risk
|Moderately Aggressive Investors
|Moderately high risk funds are suitable for investors who are willing to take on additional risk in order to maximize their prospective rewards over the medium to long term.
|High risk funds are suitable for investors who are willing to take large risks in order to optimize long-term profits and are conscious that they may end up losing all or most part of their investment.
|Very High Risk
|Very Aggressive Investors
|Very high-risk funds are suitable for investors who are willing to take extremely high risks in order to optimize long-term profits and are conscious that they may lose all or a large portion of their investment.
How to Interpret Riskometer While Selecting a Mutual Fund?
The riskometer will help you assess the risk levels of a mutual fund. Knowing the risk levels of a fund will help you pick the right fund that matches your risk tolerance levels.
The low-risk category includes securities and instruments such as income funds, gilt funds, and fixed maturity plans (FMPs). Since the risk levels are low, they are the safest mutual funds. Thus, ideal for investors seeking a steady stream of income.
Low to Moderate Risk Level
Fund under this category includes short to medium-term bonds. They are considered safe investments and best suited for investors who can commit to a three-year to five-year investment horizon.
Moderate Risk Level
Funds in this category have a moderate risk of losing their principal. Arbitrage funds, MIP funds, and hybrid debt-oriented funds are appropriate for the moderate investor seeking to earn reasonable returns while limiting risk. These funds also require a medium- to the long-term investment horizon.
Moderately High-Risk Level
Funds in this category have a relatively high risk of losing their principal. Typically, this category includes equity funds, debt funds and hybrid funds. The products sold under this label are ideal for investors looking to build wealth over time.
The high-risk level category includes highly risky funds. These funds predominantly invest across equities. Sectoral funds, theme funds, foreign funds, and high credit risk funds are just a few of the funds that fall under this classification. This classification is appropriate for investors looking to build wealth over time and comfortable with the high risk for their investment.
Very High Risk
The very high-risk level category includes extremely risky funds. These funds predominantly invest in highly volatile stocks. Small-cap funds and mid-cap funds are some of the types of funds that fall under this category. Funds that belong to a very high-risk level category are suitable for investors with a long-term investment horizon. Furthermore, they are aware that they are at risk of losing their part or entire investment amount.
Given the broad universe of mutual funds, investors can use the new riskometer as one of their criteria to select funds that align with their risk tolerance levels. This metric is beneficial for investors who wish to assess the fund’s risk levels and see if it aligns with theirs.
However, it is critical to remember that while the riskometer can provide an overview of the risk level, it cannot be the sole criteria for investing in a fund. There are several other factors to consider when selecting a fund, such as your investment objective, investment horizon, the historical performance of the fund, etc.