Investing in mutual funds involves a certain degree of risk, and investors must clearly understand the associated risks. Hence, a riskometer in mutual funds is a valuable tool designed to help investors gauge and assess the risk levels associated with a particular fund. In this article, we will understand the riskometer, the types of risks it measures and how investors can interpret this metric.
What is a Riskometer in Mutual Funds?
The riskometer is a graphical representation or a numeric scale that depicts the level of risk associated with a mutual fund scheme. It serves as a guide for investors to gauge the potential volatility and uncertainty linked to a specific fund. Simply put, it shows the risk based on a fund's underlying portfolio rather than the category-level risk.
For instance, if a liquid mutual fund invests in bonds with higher credit risk for increased returns, the riskometer of the fund will show higher risk even though the liquid fund category is a low-risk category.
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This graph was first designed in 2015 under the SEBI guidelines. Now, SEBI has made it mandatory for all mutual fund houses to display the riskometer showing the five risk categories. As per the guidelines, the colour codes must be present on the front page of the scheme application form. These colour codes correspond to the respective scheme's associated risk.
Types of Risks Measured Through Riskometer in Mutual Funds
The fund houses need to assess the risk level of all schemes every month. They consider the underlying securities of the scheme, i.e., equity, debt, derivatives, etc., and the scheme's AUM. Therefore, as per SEBI, the AMC must assign a value for underlying securities to determine the risk level. The following are the risk parameters for the two categories –
Equity Funds
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Market Volatility Risk: The potential for the value of investments to fluctuate due to changes in market conditions. This is also known as systematic risk, which is affected due to macroeconomic factors.
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Management Risk: This risk arises due to ineffective or underperforming management by the fund manager.
Debt Funds
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Credit Risk: This is the risk of default by the issuer of a debt instrument held by the mutual fund. Thus, when the credit risk is high, the chances of default are also high. At the same time, the debt fund risk score is also high.
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Interest Rate Risk: This risk is related to changes in interest rates which impacts the fund's performance. In other words, the bond price falls when the interest rate rises. Also, they are more sensitive to interest rate movements when the bond duration is longer. Thus, the risk score is high for funds with longer maturities.
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- Liquidity Risk: This risk associated with the ease of buying/selling the debt securities in the market. The risk score becomes high for funds which invest in illiquid debt securities.
Different Risk Levels in Riskometer
The riskometer categorizes mutual funds into different risk levels, ranging from low to high. Below is a simplified representation of the risk levels:
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Conclusion
The riskometer in mutual funds is a valuable tool helping investors make informed decisions by quantifying the level of risk associated with a particular fund. Also, it helps investors align their risk tolerance with the fund’s risk profile and create a portfolio based on their financial objectives.
However, risk cannot be the sole parameter for the decision-making process. Investment requires a comprehensive approach while selecting a fund. Thus, investors should also consider their investment horizon, fund past performance, fees and expenses and other factors.
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