Mutual Funds Risks: Cracking the Risk Rainbow Without Being Colour Blind
18 December, 2024
Synopsis
- Risk meters are mandatory graphical tools showing mutual fund risk levels on a 5-point scale.
- Very high-risk funds have values above 18, while low-risk funds have values up to 3.
- Investment decisions should consider risk meters alongside other factors.
- Regular review of risk ratings is important as risk levels can change.
Before getting a driving licence, you undergo a test where you are required to know the meaning of different roads and traffic signs. The idea is to make you aware of the signs so that you know about potential dangers while driving. For example, when driving through hilly terrain, various signs warn you about the danger of sharp turns, landslides, rough roads, etc. The mutual fund investment journey, too, can be bumpy, with market volatility. But is there an early warning system that warns you about the possible risks? You must be thinking. Well, the answer is yes. To help investors assess the risk levels of a mutual fund before investing, the SEBI has mandated all funds to have a risk-o-meter. But how exactly does one read these risk meters?
What is a Risk Meter?
A risk meter is a graphical representation of the risk associated with a mutual fund scheme. It aims to convey the risk level of a fund through a simple 5-point scale indicator from low to very high. The SEBI has made risk meters mandatory since 2020 for all mutual fund schemes to improve transparency for investors.
Risk meters are based on a fund's portfolio and categorisation. Equity funds are riskier than debt funds. Each mutual fund must prominently display the risk meter in scheme-related documents to help investors assess suitability.
How are Risk Meters Calculated?
SEBI has outlined a specific framework for mutual funds to calculate risk value for the 5-point risk meter:
Very High Risk - Fund with risk value greater than 18
High Risk – Fund with risk value between 12 and 18
Moderately High Risk – Fund with risk value between 6 and 12
Moderate Risk – Fund with risk value between 3 and 6
Low Risk – Fund with risk value up to 3
The risk value is calculated using the annualised standard deviation of the fund's weekly returns over the last 3 years. Standard deviation measures the volatility of returns – the higher the volatility, the higher the risk.
Based on standard deviation values, mutual funds determine the risk rating on a scale of 5 to 25. This risk level is then converted into the 5-point qualitative risk meter based on the bands defined by the SEBI.
Understanding Mutual Fund Risk Meter of Different Fund Categories
Here's a look at the typical risk ratings associated with major mutual fund categories:
Equity Funds - Very High to High Risk
Equity funds predominantly invest in stocks. Stocks tend to be volatile; hence, equity funds carry very high to high-risk ratings on the meter. Within equities, multi-cap and mid-cap funds are riskier than large-cap funds.
Debt Funds - Low to Moderate Risk
Debt mutual funds invest majorly in fixed-income securities like bonds, g-secs, etc. These products are less volatile than equities. Hence, debt funds have low to moderate risk meters. Short-duration funds are less risky than long-duration funds.
Hybrid Funds - Moderate to Moderately High Risk
Hybrid funds invest in both equities and debt in different proportions. As a result, they have moderate to moderately high risk on the meter. Conservative hybrid funds are less risky than aggressive hybrid funds.
Solution Oriented Funds
These funds have strategised portfolios aligned to financial targets like retirement planning or child education. Solution-oriented funds can have moderate to high-risk meters based on their equity and debt allocation.
Index Funds/ETFs - Risk Depends on Underlying Index
Index funds and ETFs mimic a particular stock or bond index. They carry the same level of risk as the underlying index. For example, the Nifty index fund has a very high risk like the equity index it tracks.
Fund of Funds - Risk Depends on Underlying
Fund of funds invest in other mutual fund schemes. Their risk profile mirrors the cumulative risk levels of the underlying funds in their portfolio.
Limitations of Risk Meters
While risk meters serve as a good starting point, they also have some limitations:
They capture historical volatility based on the last 3 years' returns. The future risk profile may differ.
Within a category, risk meters don't differentiate between funds. For example, all multi-cap funds have the same risk level.
They focus only on volatility risk, not liquidity or credit risk.
They do not indicate potential fund returns, only the risk.
Therefore, investors should not solely rely on risk meters. They should also consider portfolio holdings, fund objectives, manager track record, etc., to make informed decisions.
How to Invest Based on Risk Meters?
Some tips to utilise risk meters effectively while investing in mutual funds:
Gauge your risk appetite and investment horizon before selecting any fund. Know your ability and time frame to bear risks.
Choose funds with risk meters that match your risk tolerance and investment period. Do not invest in high-risk funds if you have a low-risk appetite.
Build a balanced portfolio with low, moderate and high-risk funds. Combining equity, debt, and hybrid funds helps diversify and mitigate risks.
You may opt for lower-risk funds within the same fund category. For instance, banking sector funds carry lower market risk than diversified equity funds.
Review risk ratings periodically since risk levels can change. Opt to switch to lower-risk funds as you near essential objectives.
Do not get misguided solely by potentially higher returns from high-risk funds. Focus on your actual risk capacity.
Beyond the risk meter, analyse portfolio, fund manager credentials, expenses, etc., to make informed decisions.
The risk meters give a quick snapshot of the riskiness of a mutual fund scheme. When used prudently along with other fund evaluation parameters, they can help investors construct portfolios that align with their risk appetite and investment objectives.
Curious to know about how risk meters can guide your investment decisions? Download the HDFC Bank SmartWealth App from the Playstore/Appstore today to make informed choices and align investments with your financial objectives.
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