Is an equity fund riskier than a debt scheme?
Conventional wisdom would say an equity fund is riskier than a debt scheme. But what happens if your debt fund takes considerable credit risks and your equity scheme is a relatively safer large-cap index fund? From the events of the past two years, we now know that the former can get quite risky, even lethal. That’s the anomaly that SEBI’s latest revised product labeling – or risk-o-meter – guidelines (issued on October 5, 2020) seek to address. Through a scoring mechanism for various parameters, MFs will grade each investment in the scheme between 1 and 14. The least risky investment will be given a score of 1. For example, an AAA-rated PSU debt instrument will get a score of 1 on both credit and liquidity risks.
After your fund house computes the risk levels of every underlying instrument, it needs to arrive at a final score, which can be less than 1 or more than 5. Accordingly, its risk label will then be classified as ‘low risk’, ‘low to moderate’, ‘moderate’, ‘moderately high’, ‘high’, and ‘very high’.
Here is a look at how the new risk-o-meter can help MF investors take an informed decision.
Not just credit risks, liquidity also important
Currently, your debt fund’s risk level is being largely determined by the credit rating of its underlying instruments. While credit rating is important, it’s also necessary to assess how liquid the scheme’s investments are. The new risk-o-meter takes into account both factors.
For instance, an AAA-rated listed instrument will now be assigned a lesser risk score (2) than unlisted AAA-rated security, or one that comes with a credit enhancement (3). A credit enhancement is a structure whereby the borrower (in this case, the company in whose security the debt fund invests) attaches collateral to improve its own creditworthiness. If the debt structure allows and the value of these collateralized shares falls below a certain level, it gives the right to the mutual fund to sell and recover the dues.
“As the new methodology adopts a conservative approach on risks, the idiosyncratic risks of a portfolio will also get picked up,” says Dwijendra Srivastava, chief investment officer-debt, at Sundaram MF.
Credit risk scores will be based on the credit rating of the debt securities. The liquidity risk’s scores would take into an account credit rating, as well as aspects such as credit enhancement, listed or unlisted debt, and the put option. An unrated or below-investment-grade debt will get the worst score of 14 on liquidity risk value. MFs will have to arrive at the liquidity and credit risk values of the debt scheme portfolio, based on the weighted average scores of these parameters.
The new risk-o-meter will now also look at duration-strategy funds closely. Hybrid funds that invest in debt securities would now be subject to such rigorous scrutiny on the debt side of their portfolios.
The final risk value assigned to the scheme would be a simple average of the scores of various parameters. For example, a portfolio with risk value of one or less will be graded as a low-risk fund, a portfolio with a risk value of between 4.1 and 5 will be graded as high-risk, while a risk-value of more than 5 would be deemed to be of ‘very high-risk’ grade.
Throwing light on credit risks
With the new fund categorization norms, duration strategy schemes are technically allowed to take higher exposure to lower-rated debt papers. However, these funds do not follow the prudent credit risk exposure norms that SEBI laid down for credit risk schemes. Thus, investors could end up losing a substantial portion of their money.
The new risk-o-meter framework lays down a set of parameters to factor in the credit risk in every debt scheme portfolio, irrespective of the category. The liquidity risk of the scheme would also have to be considered, which tends to be high in schemes exposed heavily to lower-rated corporate debt. In other words, an ultra-short duration fund can be just as risky as a credit risk scheme.
“A shorter duration fund, which has higher credit risks, will now get graded as a higher-risk scheme in its category. This can keep investors on the alert when they are evaluating such a scheme,” says Vidya Bala, co-founder of Primeinvestor.in
Gauging risks in equity schemes
The new risk-o-meter methodology also aims at giving a more accurate picture of the risks in equity schemes. Within certain equity categories, fund managers have a wide room to take higher exposure to mid and small-cap stocks. However, such investment decisions are unlikely to reflect in the existing product labels. The risk-o-meter will consider all investments in large, mid, and small-caps, and accordingly assign a market-cap score to the equity scheme.
“In categories such as large and mid-cap, value, contra or focused, there can be stark differences in market-cap orientation in different portfolios. The new risk-o-meter would factor in higher exposure to mid- and small-cap stocks or stocks with high volatility, and grade those schemes as higher-risk funds in their respective categories,” Bala says.
The final risk value of an equity scheme will also consider the volatility and impact cost of investments.
Your scheme’s risk-o-meter every month
Earlier, a scheme could take more risks as it gets older, without it getting reflected in the risk-o-meter at the time of its launch. If you just invest in it going by its risk-o-meter, you might not get the true picture of what the scheme actually does.
Not anymore. Your fund will now have to evaluate it on a monthly basis. Experts say that over time the risk-o-meter would give the path that a scheme has taken. “Like the industry has created a NAV history, now it can also create a risk history for schemes. This risk-o-meter has the potential to finally start the discussion on risks,” says Swarup Mohanty, chief executive officer at Mirae AMC.
More people talking about a scheme’s risk-o-meter may usher in a new way of selecting the right mutual fund scheme. “The MF industry should start talking more about risks and the new risk-o-meter so that investors’ focus shifts from just looking at past returns. All rating and ranking of schemes, which are just based on past returns, should now also focus on risks as SEBI has created a whole new framework for this,” says Jimmy Patel, managing director, and chief executive officer of Quantum MF.
Fund houses have time till January 1, 2021, to come out with new sets of product labels or risk-o-meters for all their schemes.