SEBI’s new risk meter for MFs: Not flawless, but much better than the earlier version

Gauging debt fund risks

From 2021 onwards, the new mutual fund Riskometer will have six levels of risks for mutual funds.

-Low Risk

-Low to Moderate Risk

-Moderate Risk

-Moderately High Risk

-High Risk and

-Very High Risk

For the calculation of the value of Riskometer for Debt Funds, three categories of risk –credit, interest rate and liquidity – shall be assessed. And the risk value (which will be used to assign the Riskometer risk) for the debt fund portfolio shall be a simple average of credit, interest rate, and liquidity risk values.

Let’s go deeper into these three risks and their calculations.

Credit Risk

The securities part of the debt fund portfolio shall be valued for credit risk on a scale of 1-12 (with 1 being the least risky) as follows:

-Rating 1: G-Sec/AAA/SDL/ TREPS

-Rating 2: AA+

-Rating 3: AA

-Rating 4: AA-

-Rating 5: A+

-Rating 6: A

-Rating 7: A-

-Rating 8: BBB+

-Rating 9: BBB

-Rating 10: BBB-

-Rating 11: Unrated

-Rating 12: Below investment-grade

Since the debt fund portfolios have several components, the weighted average value of each instrument (based AUM: assets under management), the credit risk value of the portfolio shall be calculated.

So let’s say a debt funds is made up of 60 percent in AAA rated papers, 30 percent AA- and 10 percent in BBB, then the credit risk value will be (0.6*1)+(0.3*4)+(0.1*9) = 0.6+1.2+0.9=2.7

Interest Rate Risk

The Interest rate risk of a debt fund shall be valued using Macaulay Duration of its Portfolio. A scale of 1-6 shall be used as follows:

-Rating 1: Macaulay Duration < = 0.5 years

-Rating 2: 0.5-1 year

-Rating 3: 1-2 years

-Rating 4: 2-3 years

-Rating 5: 3-4 years

-Rating 6: > 4 years

Do note that this duration is for the average duration of the portfolio and not for each paper/bond held by the fund’s portfolio. It’s still possible that a fund’s average portfolio may have low Macaulay duration but a few bonds may have maturity years later.

Liquidity Risk

To assess the liquidity risk, SEBI has provided a very detailed guideline which ranges from a scale of 1 to 14, with 1 being the least risky from a liquidity perspective.

And how will these three types of risk values be used to calculate the overall risk value of the portfolio?

It will use the formula to give one single number for Portfolio Risk, as follow:

Portfolio Risk = Simple Average (Credit, Interest Rate, Liquidity Risk)

But in case the liquidity risk value is higher than the simple average of all three risk values, then the liquidity risk value shall be considered as the overall risk value of the debt portfolio.

The calculated risk value will then be used to allocate the risk level as follows and decide the position of the arrow in Riskometer:

-Risk Value <= 1: LOW

- 1< Risk Value <= 2: LOW to MODERATE

- 2< Risk Value <= 3: MODERATE

- 3< Risk Value <= 4: MODERATELY HIGH

- 4< Risk Value <= 5: HIGH

- 5< Risk Value: VERY HIGH

So, as is evident, there is a method now to arrive at risk rating for the debt funds. It may still not be perfect, but it’s enormously better than what was being done earlier. Why not perfect? Because it’s still possible to use different combinations of portfolios to arrive at similar risk ratings. But nevertheless, it’s a step in the right direction and hopefully, will make the Riskometer more useful for investors than it earlier was.

So, no doubt, the Riskometer now captures inherent risks in mutual fund portfolios much better. But still, one cannot depend solely on it. An investor still needs to understand what different debt fund categories are and suitable for different goals and then pick right funds amongst them.