Risk-O-Meter Scheme by SEBI

Introduction:

Risk-o-meter is a risk evaluation scheme launched by the Securities and Exchange Board of India (SEBI); this scheme is used to analyse the level of risk involved while investing in various securities by applying certain parameters which are prescribed and modified by the Board itself from time to time. The latest iteration of Risk-o-meter came into effect on Jan 1, 2021, which was informed by SEBI in its circular dated 05.10.2020, in which it laid down detailed instructions for the Mutual Funds and Asset Management Companies to award a risk level to various securities handled by them as per the methodologies suggested in the same circular.^[1] The majority of the suggestions made by the SEBI in the said circular were influenced by the recommendations of the Mutual Fund Advisory Committee (MFAC) which is constituted by the SEBI to advise itself on matters related to Mutual Funds for ensuring investor protection and the complexities of Mutual Funds market development.^[2]

The scheme was launched by SEBI under its Go-Green initiative which was primarily focused on labelling of Mutual Funds, in line with its purpose to regulate the securities market more effectively,^[3] promoting a fair environment and safeguarding the interests of the investors by providing them with detailed risk analysis so that they can make more informed choices.

Legal Domain and Working Procedure

Broadly, the Risk-o-meter scheme applies to the various investment portfolios even before their launch. The Mutual funds were mandated to assign a risk level to all their portfolios after detailed risk analysis as per the methodology provided in the circular dated 05.10.2020 issued by SEBI invoking its broad powers under Section 11(1) of the Securities and Exchange Board of India Act, 1992 and relevant regulations of SEBI (Mutual Funds) Regulation, 1996. The scheme works on a scale of six levels of risks namely: Low, Low to Moderate, Moderate, Moderately High, High and Very High in the increasing order of risk level assigned numerical values 1-6 being with the upper value of the numerical included.^[4]

The Fund Houses have to disclose the risk-o-meter of their portfolios on the website of the Association of Mutual Funds of India (AMFI) as well on their web portals in such a manner that they are easy to locate by any potential investor/ investor/another person along with the portfolio disclosure of the Mutual Funds schemes held by them.

The frequency of disclosure is dependent on the dynamic market parameters governing the variations in risk levels of the portfolios. Further, it is required of Fund houses to disclose the risk-o-meter on the last day of the financial year i.e., 31^st March and update it every month within the first 10 days.

Parameters used for Determining the Risk Level of Various Portfolios^[5]

1. Debt Securities: Credit Risk, Interest Rate Risk and Liquidity Risk (availability of cash).
2. Equity: Market Capitalisation, Volatility and Impact Cost (Liquidity Measure).
3. Equity Derivatives: Quantity of derivative position held more than the value of hedging position.
4. Index Futures and Stock Futures: Volatility of index value.
5. Other Derivative instruments: excess quantity of derivative instrument as compared to the hedged instrument and daily volatility of the instrument.
6. REITs & InvITs- Valued as 7 from a risk perspective which will result in a very high level of risk on risk-o-meter.
7. Gold and related instruments: Valued as 4 falling under Moderately High-risk level.
8. Foreign Securities: investment by schemes is valued as 7 while other investments are assigned a risk level based on the weighted value of each security.
9. Mutual Fund Schemes: Indian mutual fund schemes are assigned risk values between 1 to 6 depending on the risk rating of the particular scheme. While foreign schemes are given a risk value of 7.
10. Cash and Net Current Assets are valued as 1 on the risk scale.

The SEBI has also directed the Asset Management Companies to disclose the risk-o-meter results along with portfolio labelling information like name and performance of the benchmarks handled by them, as directed under its Go-Green initiative for Mutual Funds, in its circulars issued on the risk-o-meter scheme in April and August 2021. The risk-o-meter scheme has also expanded to promotional material advertised by the Fund houses as well as the fortnightly, monthly and half-yearly statements sent to the investors via email.^[6] The Asset Management Companies have also been directed to arrange with their respective Index providers for enabling the facilitation of risk-o-meter information within the first 5 days of every month.

Difference from an earlier version of the Scheme

The earlier version of the risk-o-meter employed by the SEBI in 2015 was more of a static scheme while the latest iteration is more accommodative towards the dynamic nature of the Securities Markets. The original risk-o-meter consisted of five risk levels namely Low, Low to Moderate, Moderately High, Moderate and High. Although the risk levels remain largely the same with just adding to the latest version of risk-o-meter, the former catered to the fund categories as a whole, where a risk level was assigned by default to a portfolio category by the SEBI. The assigned risk level covered all the funds available under a particular category. The blanket risk level was assigned by the SEBI after analysing the broad parameters applicable to the particular portfolio.^[7]

This resulted in an apparent superficial allocation of risk categories to different types of portfolios handled by Fund Houses with minimal or no actual corresponding insights for potential investors while choosing various funds. With the risk level remaining stagnant even with changes in the risk factors, the categorisation eventually became a tag just for the sake of it.^[8] The underlying shortcomings of the contemporary risk-o-meter resulted in miscalculation by investors while calculating the looming market risks leading to failure in timely encashing of funds. On the other hand, the latest risk-o-meter tends to dive deeper within a particular category of portfolios, taking into account the actual risks and keeping track of the changes within the same, also updating the risk level as per the dynamics of risk parameters.

Due to the dynamic nature of the new risk-o-meter has the potential to transform the role of common investors with little knowledge whatsoever, as far as the concept of investment portfolios is concerned who relied on the allocation of risk level by the SEBI earlier. Now, the investors are entitled to fortnightly, monthly and half-yearly performance reports summarizing the risk-o-meter within them, which translates to a proactive role by both the investors and the Fund Houses as a responsibility to keep track of the changes in the risk parameters which have a direct effect on the risk level of a portfolio.

It also avails the investors of choice within the portfolio categories about the unique nature of parameters as well as their effect on the portfolio, with useful information readily available on changes in the risk levels as they are happening via dedicated links on the website of the Mutual Fund without overwhelming the investor with swaths of data.^[9] In a way, the new risk-o-meter will go a long way in creating an environment of trust and security among the investors, improving the credibility of Mutual Funds and taking a step further towards the goal of effective regulation of Security Markets envisioned by the SEBI.

How does it translate into reality?

The concept of Risk-o-meter sounds very promising on paper barring the complexities facing the Fund Houses and the investors for practical purposes. Although, the Asset Management Companies and Mutual Funds have started sending separate risk-o-meter changes via links attached to periodic emails sent to the investors which are more often than not are cryptic mails with loads of information although marked relevant as per the sender but incomprehensible for a common investor. This hurdle has created a hurdle in realising the purpose of the scheme.

On a side note, the SEBI has directed the Mutual Funds and Asset Management Companies to invest in the schemes which are promoted by them as a token of trust, which can prove to be a major game changer in aligning their interests with that of the investors. The extent of investment varies depending on the risk level of the scheme and its size.^[10] Further, the SEBI has also instructed the Mutual Funds and Asset Management Companies to narrow down the risk-o-meter information sent to the investors to the specific schemes that they are invested in, to simplify the process.^[11] Schemes based entirely on liquidity i.e., cash in physical form as well as overnight schemes are excluded from the Risk-o-meter scheme by the SEBI.

Conclusion

Overall, the Risk-o-meter schemes lean towards the beneficial side as it has made the investment process more investor-friendly ensuring active involvement on their part as well as consisted efforts on part of the Mutual Funds and Asset Management Companies to continuously monitor the variations in the specific parameters in real-time which influence the allocation of risk level to a particular Mutual Fund Scheme. Barring a sense of paranoia and stress from people already invested with various portfolios which suffered a risk level change for the worse after revamping of the Risk-o-meter scheme, it has received a positive response from the investor community. It will play a crucial role in allaying the concerns and uncertainties of the Mutual Funds schemes along with other indexes which the Mutual Funds usually invest into, among the investors. Additionally, it will incentivize the citizens as well as foreign nationals to invest in Indian Mutual Funds ensuring the protection of their interests.

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References:

[1]SEBI | Disclosure of risk-o-meter of scheme, benchmark and portfolio details to the investors, , https://www.sebi.gov.in/legal/circulars/aug-2021/disclosure-of-risk-o-meter-of-scheme-benchmark-and-portfolio-details-to-the-investors_52262.html (last visited Dec 9, 2021).

[2]Very High Risk! SEBI introduces a new level of risk for mutual fund schemes: Know how it helps, , The Financial Express (2020), https://www.financialexpress.com/money/mutual-funds/very-high-risk-sebi-introduces-a-new-level-of-risk-for-mutual-fund-schemes-know-how-it-helps/2099093/ (last visited Dec 9, 2021).

[3]Bhumika Indulia, SEBI issues circular on disclosure of risk-o-meter of scheme, benchmark and portfolio details to the investors, SCC Blog (2021), https://www.scconline.com/blog/post/2021/09/01/sebi-issues-circular-on-disclosure-of-risk-o-meter-of-scheme-benchmark-and-portfolio-details-to-the-investors/ (last visited Dec 9, 2021).

[4]Explained: How the mutual funds risk-o-meter will work, , The Indian Express (2021), https://indianexpress.com/article/explained/explained-how-mf-risk-o-meter-will-work-7145337/ (last visited Dec 9, 2021).

[5] Supra 1.

[6]Press Trust of India, Sebi asks AMCs to disclose details of risk, performance of MF schemes, Business Standard India, August 31, 2021, https://www.business-standard.com/article/markets/sebi-asks-amcs-to-disclose-details-of-risk-performance-of-mf-schemes-121083101188_1.html (last visited Dec 9, 2021).

[7]Dhirendra Kumar & Preeti Motiani, Sebi’s new risk-o-meter for mutual funds is a useful tool but investors need to understand it first, The Economic Times, February 15, 2021, https://economictimes.indiatimes.com/wealth/invest/sebis-new-risk-o-meter-for-mutual-funds-is-a-useful-tool-but-investors-need-to-understand-it-first/articleshow/80893207.cms (last visited Dec 9, 2021).

[8]Aarati Krishnan, How to read the new mutual fund risk-o-meter, businessline , https://www.thehindubusinessline.com/portfolio/mutual-funds/how-to-read-the-new-mutual-fund-risk-o-meter/article33588715.ece (last visited Dec 9, 2021).

[9]SEBI Issues Further Guidelines For Disclosure Of Risk-o-meter To Mutual Funds, , Moneycontrol , https://www.moneycontrol.com/news/business/personal-finance/sebi-issues-further-guidelines-for-disclosure-of-risk-o-meter-to-mutual-funds-7412631.html (last visited Dec 9, 2021).

[10]Chirag Madia, Sebi directs MFs to show more skin in the game, invest more in own schemes, Business Standard India, September 3, 2021, https://www.business-standard.com/article/markets/sebi-directs-mfs-to-show-more-skin-in-the-game-invest-more-in-own-schemes-121090301078_1.html (last visited Dec 9, 2021).

[11]Id.